In the thirty or so years since the modiglianimiller theorem, scholars have worked to relax the theorems assumptions in order to obtain a better understanding of the capital structure of firms. An important purpose of the tradeoff theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity. The traditional approach strikes a compromise between the first two theories. Making capital structure support strategy the issue is more nuanced than some pundits suggest. Despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. Meaning and definition of optimal capital structure. Capital structure theories help us to understand the relationship between the capital structure, cost of capital and value of a firm. The optimal capital structure theory is well articulated in the literature and it was also the prevailing theory of optimal capital structure for a long time ibid. Optimal capital structure and growth options in mergers and acquisitions. It is the mix of debt, preferred stock and common equity that minimizes risk. Optimum capital structure f9 financial management acca. The tradeoff theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The impact of adjustment in capital structure in mergers. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to finance its core operations through equity.
The relationship between capital structure and merger decisions is still not. In capital structure models, the valuation of corporate securities and financial decisions are jointly determined. However, present investors can hedge against this risk by holding both the bonds and stock of the corporation in their portfolios. The major limitation of this study is rooted in the selection of five companies. It is the employment of an asset source of finance for which. Starting with the seminal work by modigliani and miller, much attention has been paid to the optimality of capital structure from the shareholders point of view. Thus the higher the risk and volatility in the economy, the lower the proportion of debt in the capital structure should be. Hypotheses the following hypothesis is formulated for the study h 0. A theoretical and empirical study of how capital structure influences the performanceandenterprisevalue. Using cokecola and pepsico to demonstrate optimal capital. Debt, equity or preferred stock b the cost of each component n in summary, the cost of capital is the cost of each component weighted by its relative market value.
Alternative methods to determine optimal capital structure. Thus, the evidence provided in this study may be viewed as a complementary to the above timeseries evidence. Moving towards optimal capital structure not only increases value, but also. The pecking order theory is in sharp contrast with the theories that attempt to find an optimal capital structure by studying the tradeoff between the advantages and disadvantages of debt finance. The capital structure models incorporate contingent claim valuation theory to quantitatively analyze prevailing determinants of capital structure in corporate finance literature. Not only is it shown that an optimal capital structure can exist, but conditions which guarantee the existence of a unique internal optimal level of debt are set forth. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per.
Questions on capital structure optimal capital structure. The adjustment of capital structure in mergers and. The assumption of risk neutrality does not lose any generality. These statements are parts of the optimal capital structure theory jen et al. Chapter 4 optimal capital structure deci sion in a multicriteria. The theory and practice of corporate capital structure january 2006 2 liability strategies group executive summary this paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey.
The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. For example, at present we do not understand very well the. They invested many hours in solving this merger and. It is the mix of debt, preferred stock and common equity that maximizes profits. It says that the cost of capital is a function of the capital structure.
Exhibit 1 flow of funds between the suppliers of capital and the company the combination of debt and equity used to finance a companys projects is referred to as capital structure. Optimal capital structure and industry dynamics 2625 flows at a constant riskfree rate r 0. Pdf despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. This paper surveys capital structure theories based on agency costs. Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. Capital structure how a company finances its operations.
Pdf optimal capital structure and growth options in mergers and. Theories of capital structure explained with examples. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the wacc. Unfortunately, there has been little consensus among researchers on what the optimal capital structure is. By reconciling empirical evidence with theory practical strategies for managing capital structure in transition are suggested. The formal structure of our discussion implicitly assumes that investors will not be. In the third section the capital structure properties of the model are derived. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. In fact the search for optimal capital structured has dominated the theory of capital structure. Problems in the theory of optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of. So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at its lowest point.
Sheridan, a dynamic model of optimal capital structure november 25, 2005. The optimal capital structure in harris and raviv trades off improved. May 22, 2001 in this paper we will present an analysis of the optimal capital structure using two examples. A net income ni approach durand presented the net income approach which suggested. The capital structure of a firm is some mix of debt, internally generated equity, and new. Ensuring an optimal capital structure and securing the financing sources with the least cost of capital is as important, if not more, for corporate entities as it is for individuals. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum.
Our findings are consistent with a dynamic capital structure theory. Mm i and ii withoutwith taxes, optimalstatic tradeoff, agency. The three most basic ways to finance are through debt, equity or the issue of stock, and, for a small business. The tradeoff theory of capital structure discusses the various corporate finance choices that a. We show that capital structure decisions can be framed as multiple criteria decision problems which can then benefit from multiple criteria decision.
In this paper we will present an analysis of the optimal capital structure using two examples. It is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firms employed capital. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known. Modigliani on capital structure that emphasize on optimal capital structure. Making capital structure support strategy mckinsey. In this approach, there is no search for an optimal capital structure. This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. There is a negative relationship between capital structure and financial performance. Equity and debt capital are the two major sources of longterm funds for a firm. In the end, glazer and israel recognize this weakness and claim that their results cannot be considered as a capital structure theory.
As the theoretical literature on npo capital structure is still in its infancy, initial forays into the eld have relied on existing po theories see surveys by. A firm can raise new capital either by borrowing i. The theories on capital structure suggest the proportion of equity and debt in the capital structure. If agents are risk averse, the analysis may be conducted under the riskneutral measure see harrison and kreps 1979.
The ability of an organization to perform well in the market depends on the efficiency of its capital structure. Tot is an extension of the mm theory suggested by myers 1984. Tests of optimal capital structure theory and pecking. Normally, a capital structure theory should combine various basic finance factors together. Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity financing to use for operations and expansions.
To expand this work, this paper applies the tradeoff theory methodology to two firms with existing longterm debt within the same industry, cocacola and pepsico. The optimal capital structure for a company is one that offers a. Capital structure, pecking order theory, statictrade off theory 1. Capital structure the makeup of the liabilities and stockholders equity side of the balance sheet, especially the ratio of debt to equity and the mixture of short and long maturities. The capital structure decision aswath damodaran stern school of business. Capital structure and its 4 important theories ni, noi. Introduction determining optimal capital structure is one of the most important tasks to be fulfilled by financial managers. Tradeoff theory of capital structure basically entails offsetting the costs of debt against the benefits of debt.
In other word, optimal level of leverage is achieved. Pdf effect of mergers on capital structure of a firm american. Capital structure decisions in the biopharmaceutical industry. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debttoequity ranges thus minimizing the firms cost of capital. Chapter iii concepts and theories of capital structure and profitability. The special thing about this approach is that it believes an optimal capital structure.
Empirical evidence shows that firms increase their leverage after merger as a. This paper takes a novel approach and models capital structure in a dynamic framework, mirroring recent work in the forpro t literature. The optimal capital structure indicates the best debttoequity ratio for a firm that maximizes its value. While making any recommendations regarding the selection of optimal capital structure, there is a need to acknowledge that no readymade solution is available that could be used to develop optimal capital structure, however, effective. When the stock is traded and markets are viewed to be efficient, the objective is. This is the maximum amount of credit that can be extended by lenders. To evaluate the interrelationship between capital structure and performance to determine the determinants of a capital structure 5. Tradeoff theory of capital structure primarily deals with the two concepts cost of financial distress and agency costs.
Based on this theory, there is an optimal capital structure that maximizes the firm value by balancing between debt tax shield and. Optimal capital structure free download as powerpoint presentation. A dynamic model of optimal capital structure november 25, 2005. Capital structure a reading prepared by pamela peterson drake outline 1. First, we highlight certain inconsistencies in the debt and equity costs assumed by the harvard business school note from a number of viewpoints. An optimal capital structure is the objectively best mix of debt, preferred stock, and common stock that maximizes a companys market value while minimizing its cost of capital. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per share superficially through share buybacks.
The optimal debt ratio based on our analysis should be 37. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known empirical evidence. Top 4 theories of capital structure with calculations. Another way to generate balanced conclusions is to account for. A dynamic model of optimal capital structure by sergey. It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the cost of capital. Optimum capital structure and cost of capital n if the cash flows to the firm are held constant. The theory of capital structure milton harris ecsocman. Surveys of the theory of optimal capital structure always start with the. Capital structure theories may be classified on the basis of relevance of capital structure to the valuation of a firm.
Theoretical considerations a firm could use three methods to determine its capital structure. It proposes that there is an optimal capital structure where the wacc is at minimum and the. Large numbers of takeover activities in 1980s have also generated theories combining capital structure choices and corporate control considerations. Tests of optimal capital structure theory and pecking order.
The optimal structure would be to have virtually no equity at all, i. Tradeoff theory of capital structure world finance. Optimal capital structure capital structure is the proportion of debt and preference and equity shares on a firms balance sheet. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.