Corporate Finance: Instructor\'s Manual Applied Corporate Finance

Aswath Damodaran 358

Determinants of Optimal Debt Ratios

! Firm Specific Factors

• 
  
  
  
  1. Tax Rate
  
  
  
  


• Higher tax rates - - > Higher Optimal Debt Ratio


• Lower tax rates - - > Lower Optimal Debt Ratio


• 
  
  
  
  2. Pre-Tax CF on Firm = EBITDA / MV of Firm
  
  
  
  


• Higher Pre-tax CF - - > Higher Optimal Debt Ratio


• Lower Pre-tax CF - - > Lower Optimal Debt Ratio


• 
  
  
  
  3. Variance in Earnings [ Shows up when you do 'what if' analysis]
  
  
  
  


• Higher Variance - - > Lower Optimal Debt Ratio


• Lower Variance - - > Higher Optimal Debt Ratio
  ! Macro-Economic Factors


• 
  
  
  
  1. Default Spreads
     Higher - - > Lower Optimal Debt Ratio
     Lower - - > Higher Optimal Debt Ratio
  
  
  
  

The key determinant is the pre-tax return on market value of the firm. This

measures the cash flow generating capacity of the firm, relative to its market

value. The greater this number, the higher the optimal debt ratio should be.

Many high growth firms have low optimal debt ratios (in market value terms)

because their current operating income as a percentage of market value is a low

number

As firms mature, this ratio will rise, and the optimal debt ratios will go up. Many

firms, however, continue to behave as they did in earlier stages of growth and

use no debt. This is the period when the gap between actual and optimal debt

ratios will expand.