An optimal capital structure shows the best balance of debt to equity a company can have in order to

An optimal capital structure shows the best balance of debt to equity a company can have in order to

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital – or the rate it pays to use money – and maximize its market value. In essence, an optimal capital structure attempts to optimize a firm’s cost of capital and the market value of its securities. There should be a judicious mix of short- and long-term debt to help create a lower overall cost of capital. The cost of debt is lower than the cost of equity because interest on debt is tax-deductible. The cost of equity consists of the dividends a company pays to shareholders. Debt-holders’ claims to funds take priority over shareholders. Debt may be cheaper, but it also carries the risk of not being able to make payments on time, which can lead to bankruptcy. The company must find an optimal capital structure that minimizes the cost of financing and minimizes the risk of bankruptcy. If a company finances 40% of its efforts with debt at 5%, and the other 60% comes from equity at 10%, its average weighted cost of capital will be 8%. While this suggests that a firm would incur a cost of capital of 5% if it used debt for all of its funding, that would not be its optimal capital structure because of the high bankruptcy risk it would carry. That risk grows as a company’s debt increases. ESTIMATING THE OPTIMAL CAPITAL STRUCTURE There are several ways in which to estimate a company’s optimal capital structure. One way is to assume that other companies in the industry are operating at or near their optimal capital structures and to obtain published industry statistics from sources such as Ibbotson Associates’ Cost of Capital. While useful in some cases, these industry statistics are conglomerates of data and often include companies that are not sufficiently similar to the subject company. Also, the time frame in which the data was collected may be unclear or may not be in reasonable proximity to the date of valuation. For these reasons, published industry statistics alone many not provide a meaningful or accurate measure of an appropriate capital structure. In the following paragraphs, we describe three other methods for estimating an optimal capital structure of a company. Method One: Utilizing Guideline Companies. One way to estimate the subject company’s optimal capital structure is to utilize the average or median capital structure of the guideline companies employed in the market approach. This approach is useful because the appraiser is well aware of which companies are included in the analysis and the degree to which they are similar to the subject company. The drawback is that, again,
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
fluctuations in market prices and the staggered nature of debt offerings and retirements may cause the actual capital structure of a guideline company to be substantially different than its target capital structure. This issue is mitigated somewhat when numerous guideline companies exist and it becomes more likely that an average or median capital structure truly reflects an optimal capital structure.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern