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 wealthThere 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 Debtanalyze 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 industryAt various debt ratios, interest rates can be different

The Cost of Debt with Different Capital Structures (supposed)

2. Estimating the Cost of Equity, rsAn increase in the debt ratio also increases the risk faced by shareholders, and this has an effect on the cost of equity, rsCAPM equation can be used for cost of equityIt has been proved both theoretically and empirically, that beta increases with financial leverageIn CAPM equation, beta is the only variable that management can influence

3. Estimating the Weighted Average Cost of Capital, WACC

Estimate NOP = $400,000Tax Rate = 40%

4. Estimating the Firms ValueIf 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 PriceIf the firm has less than 40% debt, it should now recapitalize, meaning that it should issue debt and use the proceeds to repurchase stockThe 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 structureSince 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 = Wd 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