Conclusion

This chapter has provided background on four tools that can be used to analyze capital structure.

• The first approach is based upon operating income. Using historical data or forecasts, we develop a distribution of operating income across both good and bad scenarios. We then use a pre-defined acceptably probability of default to specify the maximum borrowing capacity.

• The second approach is the cost of capital - the weighted average of the costs of equity, debt, and preferred stock, where the weights are market value weights and the costs of financing are current costs. The objective is to minimize the cost of capital, which also maximizes the value of the firm. A general framework is developed to use this model in real-world applications and applied to find the optimal financing mix for Disney. We find that Disney, which had almost about $ 14 billion in debt in 2004, would minimize its cost of capital at a debt level of 30%, leading to an increase in market value of the firm of about $ 3 billion. Even allowing for a much diminished operating income, we find that Disney has excess debt capacity.

• The third approach estimates the value of the firm at different levels of debt by adding the present value of the tax benefits from debt to the unlevered firm's value, and then subtracting out the present value of expected bankruptcy costs. The optimal debt ratio is the one that maximizes firm value.

• The final approach is to compare a firm's debt ratio to 'similar' firms. While comparisons of firm debt ratios to an industry average are commonly made, they are generally not very useful in the presence of large differences among firms within the same industry. A cross-sectional regression of debt ratios against underlying financial variables brings in more information from the general population of firms and can be used to predict debt ratios for a large number of firms.

The objective in all of these analyses is to come up with a mix of debt and equity that will maximize the value of the firm.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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