The Optimal Capital Structure - Business Finance - ثاني ثانوي

8.3 The Optimal Capital Structure Key Term Optimal capital structure One of the most important managerial decisions is how much debt and how much equity to use to finance company operations. Some debt (with a lower cost of capital than equity) is beneficial to a company, but too much debt can result in difficulties. While the cost of debt is lower than the cost of equity, as an organization takes on more debt, its risk increases. More debt increases the likelihood of a company missing debt payments and going bankrupt. What is the best combination of debt and equity financing? The best combination of financing sources is known as the optimal capital structure. An appropriate balance between the amount of debt and equity results in a low cost of capital and a maximum market value. The optimal capital structure takes advantage of financial leverage without increasing financial risks too much. In effect, it minimizes the overall cost of finance to the firm. To determine the optimal capital structure, first establish the cost of each financing source and then determine which combination of these sources minimizes the overall cost. This minimum weighted average cost of capital is used to evaluate investment opportunities. The selection of investments requires knowledge of the firm's cost of capital because an investment must earn a return sufficient to cover the cost of the funds used to acquire the asset. By varying the mix of sources of capital and recalculating the weighted averages, the optimal capital structure is determined. Link to digital lesson OXXO www.den.edu. 回 Optimal capital site The combination of debt md equity that results in the lowest cost of capital and a maximum market value How would a financial manager determine the optimal capital structure? وزارة التعليم 2023-144

. FIGURE 8.4 Betermination of the Optimal Capital Structure The previous section illustrated the determination of the firm's weighted cost of capital. In that illustration, the cost of debt was less than the cost of equity because debt is less risky to the investor and the borrower may deduct interest payments to determine taxable income. If debt costs less than equity, couldn't management reduce the firm's cost of capital by substituting less expensive debt for more costly equity? As is often the answer: "It depends!" As management initially substitutes cheaper debt, the cost of capital declines. However, as debt finances a larger proportion of the firm's assets, becoming more financially leveraged, the costs of both debt and equity rise. Management needs to determine the ideal combination of debt and equity financing that minimizes the firm's cost of capital. This trade-off between debt and equity must be understood by corporate executives. A company should maintain a wise debt level based on its cash flow, interest payments, and ratio of debt to capital. Debt financing can lower the overall cost of capital, which will increase the return on shareowner equity. The process for determining the optimal capital structure is illustrated in Figure 8.4. Proportion of Cost of Deln Debt Financing Cost of Equity Weighted Cost 0% 4% 10.0% 10.00% 10 4 10.0 09 40 20 4 100 08 80 30 A 10.9 08 20 AB 117 au 50 5 11.5 08 25 60 6 190 08 20 70 & 15.0 10.10 80 10 18.0 1160 90 15. 22.0 157 336Business Finance ■The first column in the table presents the proportion of debt financing. ⚫ The second and third columns give the after-tax cost of debt and the cost of equity, respectively. To simplify this example, the firm has no preferred stock. The cost of debt is less than the cost of equity, and both are initially constant over a range of debt ratios. The cost of both debt and equity starts to rise as the firm becomes more leveraged.

The fourth column presents the weighted-average cost of capital, based on the cost of debt and the cost of equity, weighted by the proportion of assets financed by each of them. If the firm is entirely financed by equity, the weighted average cost of capital is the cost of equity. When the firm begins to substitute the less expensive debt financing for equity financing, the weighted average cost of capital is lower. As the use of debt increases, the weighted average cost of capital initially declines. However, this decline does not continue indefinitely as the firm substitutes additional cheaper debt. Eventually, both the cost of debt and the cost of equity begin to increase because creditors and investors believe that more financial leverage increases the riskiness of the firm. At first, small increases in the cost of debt and equity will not be great enough to deter the decline in the weighted cost of capital. However, as the costs continue to increase, the average cost of capital reaches a minimum and then starts to increase. In Figure 8.4, this optimal capital structure occurs at 40% debt (40% debt financing to 60% equity financing). As additional debt is used, the costs of both debt and equity rise sufficiently so that the cost of capital increases. This determination of the optimal capital structure is also illustrated by Figure 8.5, which plots the cost of debt (k), the cost of equity (k.), and the weighted average cost of capital (K) from Figure 8.4. As the graph shows, when the use of debt increases, the weighted average cost of capital initially declines, reaches a minimum at debt of 40% (D1 = 40% and k = 7.9%), and then starts to increase. 20% 18 16 IA 12 10 La Ca Ky B 6 وزارة التعليم " 2 10 20 30 40 50 60 70 80 90 D Delt/Total Opal Cap S Assets (%) FIGURE B.S Cast of Capital CHAPTER Cost of Capital 337

338 Business Finance . 2921-4885 The optimal capital structure is reached at the minimum point on the weighted average cost of capital line. The financial manager should plan to use this combination of financing because it involves the lowest cost of funds. This minimum cost of capital should be used to assess potential investments. As the firm expands with additional equipment and buildings, funding sources must also expand. These additional sources should maintain the firm's optimal capital structure. However, if additional investments increase the riskiness of the firm, then the cost of the additional funds will increase. In that case, the cost of the marginal (additional) funds will exceed the firm's weighted-average cost of capital. 15 For many companies, the optimal capital structure is a range of debt financing. In the example in Figures 8.4 and 8.5, the weighted-average cost of capital has little variation for debt financing in the 30% to 50% range. This indicates that the positive impact of debt financing in lowering the firm's cost of capital is achieved when 30% of the firm's assets are debt financed. Additional use of debt has little impact on the cost of capital until more than 50% of the assets are debt financed. As a result, the optimal capital structure may be viewed as a range of debt-to-equity financing and not just a specific combination of debt to equity. Exercises Choose the correct answer. 1. The optimal capital structure will often result in minimizing the value of the firm. True/False 2. The optimal capital structure for most companies is in the range of % debt financing. a. O b. 30-50 c. 70-80 d. 100