Optimal Capital Structure
(Under the Trade-off View)

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GLOSSARY

Equity:  For corporations, this is just another name for common stock.  Equity is the amount of money that the stockholders or owners have invested in the company.

Capital Structure:  A company's ratio of long-term debt to equity.

Optimal Capital Structure:  A "best" debt/equity ratio for a company.  This is the long-term-debt to equity ratio that will minimize the cost of capital, i.e., the cost of financing the company's operations.

Trade-off Theory:  The managers of a company should find a debt/equity ratio that balances the risk of bankruptcy (i.e., a high ratio) with the risk of using too little of the cheapest form of financing (i.e., a low ratio).  Note that the after-tax cost of debt will always be lower than the cost of financing with equity.


An Important Question

Is there a best way to finance a company? In other words, is there an optimal debt/equity ratio (or capital structure) for a company?

This is a question that has tantalized finance practitioners (like corporate treasurers) and academicians for a long time. If there is an optimal ratio of debt to equity, what the value of that ratio? And how important is it that we finance our company in that manner - are there dire consequences if we don't?

Modigliani and Miller's Pioneering Work

The first important study of the subject was performed in the 1950s by Franco Modigliani and Merton Miller. The findings of the study were shocking, controversial, and stunning in its effect on the financial community. The study stimulated hundreds of other studies over the next two decades on the subject and, through these studies, we learned an awful lot about how companies should be financed.

The study is important enough in its historical importance to deserve a page of its own, so follow this link for a summary of its findings: Modigliani and Miller's pioneering work on capital structure.

The Trade-off View of the Cost of Capital

As a result of hundreds of studies that followed Modigliani & Miller's land-breaking study, a new theory began to take shape: the trade-off theory. Is there an optimal capital structure? The answer is yes - in fact, you might even say that there is an optimal range.  There is a specific debt/equity ratio that will minimize a company's cost of capital.  (This is also the point at which the value of the company will be maximized.)  However, because the cost of capital curve is fairly shallow (like the bottom of a bowl), you can deviate from this optimal debt/equity ratio without appreciably increasing the cost of capital.  This creates a range in the bottom portion of the curve where the cost of capital is essentially the same throughout the range. (See the average cost of capital line on the graph below.)

There is a danger of getting outside of this range however.  The cost of capital will increase rapidly once you get outside the range, as shown by the blue Average Cost of Capital line in the graph below.

A company's overall cost of capital is a weighted average of the cost of debt and the cost of equity.  For example, if a company's debt/equity ratio is 30/70 and the after-tax cost of debt is 4% and the cost of equity is 10.5%, the company's overall cost of capital is (0.30 * 4%) + (0.70 * 10.5%), or 8.55%.

Let's take a company from its inception:

  1. When a company is new, it will likely be financed entirely with equity, so its average cost of capital is the same as its cost of equity (10% in the graph above for a 0/100 debt/equity ratio).
  2. As the company grows, it establishes a track record and attracts the confidence of lenders.  As the company increases its use of debt, the company's debt/equity ratio increases and the average cost of capital decreases.  In essence, the company is substituting the cheaper debt for the more expensive equity, thereby decreasing its overall cost.  (It might be useful to think of the company borrowing money, then using that borrowed money to buy back some of its common stock.  The debt goes up, the equity goes down, and the company's average cost of capital decreases because the company has substituted the cheaper debt for the more expensive equity.)
  3. Eventually, as the company's debt/equity ratio increases, the cost of debt and the cost of equity will increase.  Lenders will become more concerned about the risk of the loan and will increase the interest rate on its loans.  Common shareholders will become more concerned about default on the loans (and, in bankruptcy, losing all of their investment) and will insist on receiving a higher rate of return to compensate them for the higher risk.  Since both the cost of debt and equity increases, the average cost of capital will also increase.
  4. This results in a minimum point on the cost of capital curve.  However, the curve (for most industries) is relatively shallow.  This means that the financial manager has considerable flexibility in choosing a debt/equity ratio.  He or she wants to move to the shallow portion of the curve and, once there, remain there.  However, there is a range of debt/equity ratios that will allow the company to stay in this shallow portion of the curve.

Just remember that there is a danger in getting outside of this range.

Pecking Order Theory

The trade-off view shows us how a company SHOULD BE financed - the value of a company will be maximized if the managers keep the debt/equity ratio in the shallow portion of the curve. However, when we survey companies' managers, we find that there is a difference between theory and practice. How so? Fewer than 50% of all companies actually follow the trade-off view! (Note that this fact doesn't lessen the value of the theory though. Managers may embrace the theory but may weigh other factors more heavily given the economic conditions at the time of the decision.)

So how are these companies financed? They tend to use a competing theory to the trade-off view, called the pecking order theory.   The pecking order theory says that companies tend to finance investments with internal funds when possible and issue debt only when these internal funds are exhausted.  Since internal funds (profits that are retained in the company) are a form of equity and have a very high cost, managers are obviously not always following the recommendations of the trade-off view.

The pecking order theory says that companies finance investments by raising funds in this order:  (1) internal funds (retained earnings), (2) debt, and (3) sale of new common stock (the most expensive form of financing).

Why do financial managers do this? Much of this may have to do with convenience - the pecking order corresponds to the easiest and most convenient ways to raise money (regardless of cost). Also, minimizing cost of capital is a quantitative decision - and managers may also take certain qualitative factors into consideration when making their decision of how to finance the company.

Although a bit dated, an excellent description of capital structure (and capital budgeting), as practiced by corporate managers, may be found in this Duke University article (in pdf format).