CHAPTER 3

OPTIMAL CAPITAL STRUCTURE

Reported by:

Gonzales, Jade Kristoffer Z.

Lorenzo, Raniel C.
Magat, Jillian C.
Sayde, Joan M.
Sison, Crisanto M.

Presented to:

Prof. Medina F. Orleans

 Reporter: Crisanto M. Sison

It is the ultimate goal of the firm to maximize its market value or to maximize the
wealth of its owners. One of the ways in attaining this goal is to minimize the cost of
capital of the firm. We have learned in previous chapters that the weighted average cost
of capital of the firm is affected not only by cost of debt and equity but also by the capital
structure of the firm. Thus, the firm should maintain a capital structure that would result
to the lowest level of WACC and eventually maximize the firm’s stock prize.

Capital Structure – Mix of Debt, Preferred Equity, and Common Equity used to
finance company’s asset.

Optimal Capital Structure – The structure that maximize the market value of the
firm. The sum of Market Value of Debt (MVD) and Market Value of Equity (MVE).

MV-Firm = MVD + MVE

Capital Structure of Unlevered Firm Capital Structure of Levered Firm

(No Debt) (With Debt)

I. DETERMINANTS OF OPTIMAL CAPITAL STRUCTURE

1. Leverage – This is considered as the bridge between the risk of an asset

position and the corresponding risk of its equity.

2. Debt to Equity ratio

Debt ratio – proportion of total assets financed by debt.
Total Debt/Total Asset

Optimal Capital Structure 1

 Equity ratio – proportion of total assets financed by equity.

Total Equity/Total Asset

3. Cost of Debt (Kd) – The interest the company must pay on its debt to its
creditors.

4. Resulting Cost of Equity (Ke) – the return required by common or ordinary

shareholders from the firm. May be computed using:

 Capital Asset Pricing Model (CAPM)

Ke = rf + β (MRP)

 Expected Total Returns

Ke or Rs = [D1/Po] + g

Reporter: Joan M. Sayde

II. EFFECTS OF OPTIMAL CAPITAL STRUCTURE

1. Maximize stock price

Financial Theory supports that capital structure does not have an effect on firm value;
however, in the real world capital markets are largely based on psychology and every
move can have an impact. Raising debt can lower the overall risk of the firm provided that
the firm has not reached the point of financial distress yet. In addition, depending on the
amount of debt raised and how it will be used it may have a positive effect on the stock
price.

Optimal Capital Structure 2

 2. Minimizes WACC

The cost of debt is less expensive than equity, because it is less risky. The required
return needed to compensate debt investors is less than the required return needed to
compensate equity investors, because interest payments have priority over dividends and
debt holders receive priority in the event of liquidation. Debt is also cheaper than equity,
because companies get tax relief on interest, while dividend payments are paid out of
after-tax income.

However, there is a limit to the amount of debt a company should have, because an
excessive amount of debt increases interest payments, and the volatility of earnings and
the risk of bankruptcy. This increase in the financial risk to shareholders means that they
will require a greater return to compensate them, which increases the WACC — and
lowers the market value of a business. So, the optimal structure involves using enough
equity to mitigate the risk of being unable to pay back the debt — taking into account the
variability of the business’ cash flow.

3. Earn a high EPS (Earnings Per Share)

Earnings per share (EPS) is the portion of a company's profit allocated to each
outstanding share of common stock. Earnings per share serves as an indicator of a
company's profitability. EPS is calculated as:

EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares

When the capital structure of a company includes stock options, warrants, restricted
stock units (RSU), etc. these investments, if exercised, could increase the total number
of shares outstanding in the market.

The EPS is an important fundamental used in valuing a company because it breaks

down a firm's profits on a per share basis. This is especially important as the number of
shares outstanding could change, and the total earnings of a company might not be a
real measure of profitability for investors.

Optimal Capital Structure 3

 III. CONSIDERATIONS IN THE DETERMINE OF THE OPTIMAL CAPITAL
STRUCTURE
1. Capital Structure Theory

In financial management, capital structure theory refers to a systematic approach

to financing business activities through a combination of equities and liabilities.
Competing capital structure theories explore the relationship between debt financing,
equity financing and the market value of the firm.

2. Trade-off Theory

The trade-off theory states that the optimal capital structure is a trade-off between
interest tax shields and cost of financial distress:

Value of firm = Value if all-equity financed + PV (tax shield) - PV (cost of financial

distress)

In summary, the trade-off theory states that capital structure is based on a trade-
off between tax savings and distress costs of debt. Firms with safe, tangible assets
and plenty of taxable income to shield should have high target debt ratios. The theory
is capable of explaining why capital structures differ between industries, whereas it
cannot explain why profitable companies within the industry have lower debt ratios
(trade-off theory predicts the opposite as profitable firms have a larger scope for tax
shields and therefore subsequently should have higher debt levels).

3. Pecking Order Theory

The pecking order theory focuses on asymmetrical information costs. This

approach assumes that companies prioritize their financing strategy based on the path
of least resistance. Internal financing (retained earnings) is the first preferred method,
followed by debt and external equity financing (debt and issuance of new shares) as
a last resort.

Optimal Capital Structure 4

 4. Asymmetry of Information

This believes that the management has more information on the firm’s position and
is more likely to decide the method of financing on the basis of this information. When
the company believes it will undertake a profitable project, it will opt to finance with
debt so as to “concentrate” the profits to the current shareholders. When the company
believes it will undertake a risky project, it will opt to finance with equity so as to
“spread” the possible loss to both the old and new shareholders.

5. Management Empire-Building

Empire building is typically seen as unhealthy for a corporation, as managers will

often become more concerned with acquiring greater resource control than with
optimally allocating resources. Corporate controls imposed by a company's board and
upper-level management are supposed to prevent empire building within a
corporation's ranks. On a larger scale, it may lead to acquisitions or other decisions
that do not ultimately benefit shareholders, increase the corporation's financial health,
or bolster the company's long-term viability. The failure to screen out empire builders
can lead to corporate actions that do not necessarily provide the best growth
opportunities for a corporation and its shareholders, such as acquisitions made to
boost the control of the company's executives.

Reporter: Jade Kristoffer Z. Gonzales

IV. IN DETERMINING THE OPTIMAL CAPITAL STRUCTURE, IT MAY BE

BASED ON THE:
1. Lowest weighted average cost of capital, and/or
2. Highest Stock Price

To illustrate the determination of Optimal Capital Structure through the minimization of

weighted average cost of capital (WACC), we assume the following debt to equity ratio
with their corresponding cost of debt:

Optimal Capital Structure 5

 Debt-to-Total Equity-to-Total Debt-to-Equity Before-tax-
Assets Ratio Assets Ratio Ratio cost of debt
(wd) (we) (D/E) (kd)
0.10 0.90 0.11 7.0%
0.20 0.80 0.25 7.2%
0.30 0.70 0.43 8.0%
0.40 0.60 0.67 8.8%
0.50 0.50 1.00 9.6%

Additional information:
The tax rate (T) is 40%.
The risk-free premium (rf) is 5%.
The market risk premium (MRP) is 6%.
The unlevered beta (βU) is 1.0.

REQUIREMENTS:
1. Using the Hamada Equation, compute for the Beta coefficient for each capital
structure.
2. Using CAPM, compute for cost of equity.
3. Compute the WACC for each capital structure.
4. Determine the debt ratio and equity ratio at optimal capital structure.
5. Determine the WACC at the optimal capital structure.
SOLUTION:
This problem uses a trial and error method to determine which capital structure is optimal
which shows the lowest WACC.
Debt-to-Equity Resulting Beta Resulting Cost of WACC
Ratio (a) Equity (b) (c)
A 0.10/0.90 = 0.11 1.0667 11.4% 10.68%
B 0.20/0.80 = 0.25 1.1500 11.9% 10.38%
C 0.30/0.70 = 0.43 1.2571 12.54% 10.22%
D 0.40/0.60 = 0.67 1.4000 13.4% 10.15%
E 0.50/0.50 = 1.00 1.6000 14.6% 10.18%

A. At Debt-Equity ratio of 10%:90%.

a. New (levered) beta

𝐷
βL = βU [ 1 + (1 – T) (𝐸 )]
10%
= 1[1 + (1 – 40%) (90%)]
βL = 1.0667

Optimal Capital Structure 6

 b. Current Cost of Equity
Ke = rf + β(MRP)
= 5% + 1.0667(6%)
Ke = 11.4%

c. Weighted Cost of Capital

WACC = [kd(1 – T)(DR)] + [ke (ER)]
= [7%(1 – 0.4)(10%)] + [11.4%(90%)]
WACC = 10.68%

B. At Debt-Equity ratio of 20%:80%.

a. New (levered) Beta

𝐷
βL = βU [1 + (1 – T)(𝐸 )]
20%
= 1[1 + (1 – 40%)(80%)]
βL = 1.15

b. Current Cost of Equity

Ke = rf + β(MRP)
= 5% + 1.15(6%)
Ke = 11.9%

c. Weighted Average Cost of Capital

WACC = [kd(1 – T)(DR)] + [ke(ER)]
= [7.2%(1 – 0.4)(20%)] + [11.9%(80%)]
WACC = 10.38%

Optimal Capital Structure 7

 Reporter: Jillian C. Magat

C. At Debt-Equity ratio of 30%:70%.

a. New (levered) Beta

𝐷
βL = βU[1 + (1 – T) (𝐸 )]
30%
= 1[1 + (1 – 40%)(70%)]
βL = 1.2571

b. Current Cost of Equity

Ke = rf + β(MRP)
= 5% + 1.2571(6%)
Ke = 12.54%

c. Weighted Average Cost of Capital

WACC = [kd(1 – T)(DR)] + [ke(ER)]
= [8%(1 – 0.4)(30%)] + [12.54%(70%)]
WACC = 10.22%

D. At Debt-Equity ratio of 40%:60%.

a. New (levered) Beta

𝐷
βL = βU[1 + (1 – T) (𝐸 )]
40%
= 1[1 + (1 – 40%)(60%)]
βL = 1.4

b. Current Cost of Equity

Ke = rf + β(MRP)
= 5% + 1.4(6%)
Ke = 13.4%

c. Weighted Average Cost of Capital

WACC = [kd(1 – T)(DR)] + [ke(ER)]
= [8.8%(1 – 0.4)(40%)] + [13.4%(60%)]
WACC = 10.15%

Optimal Capital Structure 8

 E. At Debt-Equity ratio of 50%:50%.

a. NEW (LEVERED) BETA

𝐷
βL = βU[1 + (1 – T)(𝐸 )]
50%
= 1[1 + (1 – 40%)(50%)]
βL = 1.6

b. CURRENT COST OF EQUITY

Ke = rf + β(MRP)
= 5% + 1.6(6%)
Ke = 14.6%

c. WEIGHTED AVERAGE COST OF CAPITAL

WACC = [kd(1 – T)(DR)] + [ke(ER)]
= [9.6%(1 – 0.4)(50%)] + [14.6%(50%)]
WACC = 10.18%

Reporter: Raniel C. Lorenzo

To illustrate the determination of Optimal Structure through the Stock Price Optimization,
we assume the following debt ratio with their corresponding dividend per share cost of
debt:

Debt Ratio Dividend per Share (Div1) Cost of Equity (Ke)

0% ₱ 5.50 11.5%
25% ₱ 6.00 12.0%

40% ₱ 6.50 13.0%

50% ₱ 7.00 14.0%

75% ₱ 7.50 15.0%

Optimal Capital Structure 9

Additional information:

Assume that the company’s growth rate is 2%.

REQUIREMENTS:

1. What is the debt ratio at the optimal capital structure?

2. What is the equity ratio at the optimal capital structure?

SOLUTION:

To determine the optimal capital structure, the stock price (Po) must be computed. The
capital structure with the highest stock price is the optimal capital structure.

Debt Ratio Dividends per share Cost of Equity (Ke) Stock price

0% ₱ 5.50 11.5% ₱ 57.89

25% ₱ 6.00 12.0% ₱ 60.00

40% ₱ 6.50 13.0% ₱ 59.09

50% ₱ 7.00 14.0% ₱ 58.33

75% ₱ 7.50 15.0% ₱ 57.69

A. At zero debt ratio (Unlevered): B. At 25% debt ratio:

(OPTIMAL CAPITAL STRUCTURE)

P0 = _D1_
P0 = _ D1
r-g
r-g
_₱ 5.5__
_₱ 6.0__
11.5% – 2%
12.0%– 2%
P0 = ₱ 57.89
P0 = ₱ 60.00

Optimal Capital Structure 10

 C. At 40% debt ratio: D. At 50% debt ratio:

P0 = _ D1_ P0 = _ D1_
r–g r–g

₱ 6.5__ _₱ 7.0__
13.0%– 2% 14.0% – 2%
P0 = ₱ 58.33
P0 = ₱ 59.09

E. At 75% debt ratio:

P0 = _ D1_
r-g

_₱ 7.5__
15.0%– 2%

P0 = ₱ 57.69

The optimal capital structure provides the highest stock price aside from lowest
WACC. From the given expected dividends and cost of debt, the optimal capital
structure that results to highest stock price is at 25%:75% debt to equity ratio.

The firm from zero debt level (unlevered) may welcome risk through issuance of debt
securities and become a levered firm. However, the said firm should maintain
acceptable level of financial risk because high debt ratio increases not only cost of debt
but also cost of equity, thereby increasing WACC.

In addition, the firm, thru the BOD, may issue debt or equity securities to change the
capital structure. However, their decision should be in line with their goal of maximizing
the market value of the firm.

Therefore, the firm should focus on maintaining the optimal capital structure that would
result to the minimization of WACC or maximization of stock price.

Optimal Capital Structure 11

QUIZ

Name: ___________________________________ Date: __________ Score: _____________

DIRECTIONS: Write TRUE if the statement is incorrect, and FALSE if the statement is correct. 5 pts.

1. The Optimal Capital Structure is one which is purely composed of debt.

2. The market value of an unlevered firm is equal to the market value of its debt.
3. A levered firm benefits from the tax shield effect of interest expense brought about by debt.
4. A capital structure is optimal if a company is paying lesser tax and providing lower market value of the firm.
5. Cost of equity is that portion of total assets financed by equity.

DIRECTIONS: Identify what is being asked / described in the following items. 5 pts.

_____________ 1. It believes that capital structure is relevant and that financing should be done in an order.

_____________ 2. It is one that maximizes the market value of a firm.

_____________ 3. The portion of the total asset that is financed by debt.

_____________ 4. It is considered as the bridge between asset risk position and its corresponding risk on equity.

_____________ 5. The overall cost of utilizing the money supplied by creditors and/or owners.

DIRECTIONS: Complete the table using the given information and identify, in sentence form, which among the capital
structures is optimal based on WACC and Stock price, individually. (Show your solution) 2 pts. each

Debt- Before- Dividend

to- tax- Stock
Debt per Resulting Cost of
Equity cost of WACC
Ratio Beta Equity price
Ratio debt Share
(D/E) (kd)
15% 0.18 7.0% ₱ 5.30
28% 0.39 7.5% ₱ 6.20
12% 0.14 7.8% ₱ 6.75

Additional information:

The risk-free premium is 4%

The market risk premium is 8%
The tax rate is 32%
The unlevered beta is 1.78
There is no dividend growth rate.

Optimal Capital Structure 12