Afirm’soptimalcapitalstructureis that mix of debt and equity that maximizes the
stock price .At any point in time, management has a specifictargetcapitalstructure
in mind, presumably the optimal one, although this target may change over time.
Several factors influence a firm’s capital structure. These include its (1) business
risk,(2) tax position,(3) need for financial flexibility,(4) managerial conser-
vatism or aggressiveness,and (5) growth opportunities.
Business riskis the riskiness inherent in the firm’s operations if it uses no debt. A
firm will have little business risk if the demand for its products is stable, if the
prices of its inputs and products remain relatively constant, if it can adjust its prices
freely if costs increase, and if a high percentage of its costs are variable and hence
will decrease if sales decrease. Other things the same, the lower a firm’s business
risk, the higher its optimal debt ratio.
Financial leverageis the extent to which fixed-income securities (debt and pre-
ferred stock) are used in a firm’s capital structure. Financial riskis the added risk
borne by stockholders as a result of financial leverage.
Operating leverageis the extent to which fixed costs are used in a firm’s opera-
tions. In business terminology, a high degree of operating leverage, other factors
held constant, implies that a relatively small change in sales results in a large change
in ROIC.
Robert Hamada used the underlying assumptions of the CAPM, along with the
Modigliani and Miller model, to develop the Hamada equation,which shows
the effect of financial leverage on beta as follows:
b bU[1 (1 T)(D/S)].
Firms can take their current beta, tax rate, and debt/equity ratio to arrive at their
unlevered beta,bU, as follows:
bUb/[1 (1 T)(D/S)].
Modigliani and Millerand their followers developed atrade-off theory of capi-
tal structure.They showed that debt is useful because interest istax deductible,
but also that debt brings with it costs associated with actual or potential bankruptcy.
The optimal capital structure strikes a balance between the tax benefits of debt and
the costs associated with bankruptcy.
An alternative (or, really, complementary) theory of capital structure relates to the
signalsgiven to investors by a firm’s decision to use debt versus stock to raise new
capital. A stock issue sets off a negative signal, while using debt is a positive, or at
least a neutral, signal. As a result, companies try to avoid having to issue stock by
maintaining a reserve borrowing capacity,and this means using less debt in
“normal” times than the MM trade-off theory would suggest.
A firm’s owners may decide to use a relatively large amount of debt to constrain the
managers.Ahighdebtratioraisesthethreatofbankruptcy,which carries a cost
but which also forces managers to be more careful and less wasteful with share-
holders’ money .Many of the corporate takeovers and leveraged buyouts in recent
years were designed to improve efficiency by reducing the cash flow available to
managers.
Although each firm has a theoretically optimal capital structure, as a practical
matter we cannot estimate it with precision. Accordingly, financial executives gener-
ally treat the optimal capital structure as a range—for example, 40 to 50 percent
debt—rather than as a precise point, such as 45 percent. The concepts discussed
in this chapter help managers understand the factors they should consider when they
set the target capital structure ranges for their firms.
Summary 505
Capital Structure Decisions 501
