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, rs
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 = 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