Many individuals in today’s world have a goal in life, and quite often that goal is to be debt free. However, in the world of business, this is quite the opposite. Many large companies are trying to seek out the optimal capital structure. Capital structure is most often referred to as a company’s debt to equity ratio, which some investors might use to find out how risky, or safe, a company might be.  An optimal capital structure is simply, one which offers the best balance between debt and equity in order to maximise shareholder wealth.

 But, is this true that by altering the amount of debt in the total capital structure will increase shareholder value?

The traditional view seems to suggest that it is possible. Financing a business through debt is cheaper than equity; this is mainly because lenders require a lower rate of return than shareholders. So as debt is a lower cost than equity, it can be beneficial to increase gearing levels as the weighted average cost of capital would fall. The discounting of future cash flows at this new lower WACC produces a higher present value and so shareholder wealth is enhanced.

This is further enhanced by the tax relief available on debt capital.  However there is a fine line, taking on too much debt can be extremely risky, businesses with high gearing levels are more exposed to financial distress.

A theory in the 1950s, developed by Modigliani and Miller, argued against the traditional view. Their approach suggested that in perfect markets it doesn’t matter if a company has a gearing level of 60% or 5% it has no bearing on its market value. Instead the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends.

This theory, however, was based on a world without taxes bankruptcy cost and information asymmetry, and assumed that markets worked efficiently. In later years Modigliani and Miller corrected this assumption and produced another paper which factored in taxation. This led to an entirely different conclusion, being that a company interested in shareholder wealth maximisation should set their gearing level to as high as possible, as this creates a very low WACC.

Again Modigliani and Millers theory does not relate to the way companies operate today. This maybe because when the debt load is increased companies are more exposed to high levels of risk. A company too highly geared may also find its freedom of action restricted by its creditors and may suffer in terms of profits when interest costs need to be paid.

So is there an optimal capital structure for companies? I think there is an optimal structure but that optimal level of debt to equity entirely depends on the industry a company is involved with, some companies can work with high levels of debt, and others cannot. I also think that companies are more hesitant with using debt as a means of finance because of the recent recession, as it leaves them more vulnerable to changes in the market.

References 

Modigliani, F., & M. Miller, 1958, The cost of capital, corporation finance and the theory of investment. American Economic Review 48, 267-297.