Aswath Damodaran 357
Optimal Debt Ratio for Bookscape
Debt
Ratio
Total
Beta
Cost of
Equity
Bond
Rating
Interest
rate on
debt
Tax
Rate
Cost of Debt
(after-tax) WACC
Firm
Value (G)
0 % 1. 84 12. 87 % AAA 4. 35 % 40. 00 % 2. 61 % 12. 87 % $ 25 , 020
10 % 1. 96 13. 46 % AAA 4. 35 % 40. 00 % 2. 61 % 12. 38 % $ 26 , 495
20 % 2. 12 14. 20 % A+ 4. 70 % 40. 00 % 2. 82 % 11. 92 % $ 28 , 005
30 % 2. 31 15. 15 % A- 5. 00 % 40. 00 % 3. 00 % 11. 51 % $ 29 , 568
40 % 2. 58 16. 42 % BB 6. 50 % 40. 00 % 3. 90 % 11. 41 % $ 29 , 946
50 % 2. 94 18. 19 % B 8. 00 % 40. 00 % 4. 80 % 11. 50 % $ 29 , 606
60 % 3. 50 20. 86 % CC 14. 00 % 39. 96 % 8. 41 % 13. 39 % $ 23 , 641
70 % 4. 66 26. 48 % CC 14. 00 % 34. 25 % 9. 21 % 14. 39 % $ 21 , 365
80 % 7. 27 39. 05 % C 16. 00 % 26. 22 % 11. 80 % 17. 25 % $ 16 , 745
90 % 14. 54 74. 09 % C 16. 00 % 23. 31 % 12. 27 % 18. 45 % $ 15 , 355
The optimal debt ratio for the private firm is 40% but the cost of capital is flat
between 30 and 50%. The firm value is maximized at that point.
To the extent that private business owners view default risk more seriously than
stockholders in a publicly traded firm, they will probably be more cautious about
moving to the optimal.
We can extend the argument to closely held publicly traded firms. We would
expect these firms to have lower debt ratios than publicly traded firms with
diverse stockholdings.
