Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Is there an optimal capital structure for a particular company? Figure 13.3 shows that, in the US,

most companies operate with target capital structures in mind. Of the 392 CFOs surveyed by Graham

and Harvey (2001), 44% said that their company had either a ‘very strict’ or ‘somewhat tight’ capital

structure target, and another 37% said that their companies had flexible targets. Fewer than one-fifth of

CFOs said that their company had no target debt ratio or range. Less formal surveys in Australia indicate

similar patterns in the setting of capital structure targets; and a summary of some more recent surveys

support these findings by Graham and Harvey^5.

In other words, most managers behave as if they believe that some capital structures are better than

others, and they try to manage toward a particular target. But what factors determine the optimal capital

structure, and how do managers decide what leverage policy will maximise value for their companies?

One of the most important factors is the tax code.

5 Cotei, Carmen, and Joseph Farhat, ‘Worldwide Patterns in Capital Structure’, in Baker, H.Kent, and Gerald S. Martin, Capital Structure and

Corporate Financing Decisions Theory, Evidence, and Practice. New Jersey: John Wiley & Sons, 2011, pp. 111–126.

FIGURE 13.2 M&M PROPOSITION II ILLUSTRATED: THE COST OF EQUITY, COST OF DEBT AND

WACC FOR A COMPANY IN A WORLD WITHOUT TAXES

Required return

D/E ratio

WACC

ra+(ra^

–rd)D/E

r

ra

rd

1

Where:ra + (ra – rd ) = cost of equity

rd = cost of debt

WACC = ra = weighted average cost of capital

D = market value of debt outstanding

E = market value of shares outstanding

D

E