Estimating the Optimal Capital

Structure
Managers should choose the capital structure
that maximizes shareholders wealth.
A trial approach can be used to try different
capital structures and examine its effect on
shareholders wealth
There are five steps for the analysis of each
potential capital structure
5-steps in optimal capital structure
(1) Estimate the interest rate the firm will pay.
(2) Estimate the cost of equity.
(3) Estimate the weighted average cost of
capital.
(4) Estimate the free cash flows and their
present value, which is the value of the firm.
(5) Deduct the value of the debt to find the
shareholders wealth, which we want to
maximize.
1. Estimating the Cost of Debt
analyze industry conditions and prospects.
Appraise business risk, based on past financial
statements and current technology and
customer base.
Consider current market conditions and
interest rate paid by other firms in the
industry
At various debt ratios, interest rates can be
different
The Cost of Debt with Different Capital
Structures (supposed)

2. Estimating the Cost of Equity, r
s
An increase in the debt ratio also increases the
risk faced by shareholders, and this has an
effect on the cost of equity, r
s
CAPM equation can be used for cost of equity
It has been proved both theoretically and
empirically, that beta increases with financial
leverage
In CAPM equation, beta is the only variable
that management can influence
3. Estimating the Weighted Average
Cost of Capital, WACC






Estimate NOP = $400,000
Tax Rate = 40%
4. Estimating the Firms Value
If the firm has zero growth, we can use the
constant growth version



FCF (Free-cash flow) is net operating profit
after taxes (NOPAT) minus the required net
investment in capital

5. Estimating Shareholder Wealth and
Stock Price
If the firm has less than 40% debt, it should
now recapitalize, meaning that it should issue
debt and use the proceeds to repurchase
stock
The shareholders wealth after the recap
would be equal to the payment they receive
from the share repurchase plus the remaining
value of their equity.

To find the remaining value of equity, we need
to specify how much debt is issued in the new
capital structure
Since we know the percent of debt in the
capital structure and the resulting value of the
firm, we can find the dollar value of debt as
follows:
D = W
d
V
For example, at the optimal capital structure
of 40 percent debt, the dollar value of debt is
about $88,889 = 0.40($222,222).
The market value of the remaining equity, S, is
equal to the total value minus the value of the
debt.


Stock Price and Earnings per Share










Financial Information of the Firm used
in Example