When we calculated the weighted average cost of capital (WACC) in Chapter 10, we
assumed that the! rm had a speci! c target capital structure. However, target capital
structures often change over time, such changes a" ect the risk and cost of each type
of capital, and all this can change the WACC. Moreover, a change in the WACC will
a" ect capital budgeting decisions and, ultimately, the stock price.
Many factors in# uence capital structure decisions; and as we will see, determin-
ing the optimal capital structure is not an exact science. Therefore, even! rms in the
same industry often have dramatically di" erent capital structures. In this chapter, we
consider the e" ects of debt on risk and on the optimal capital structure.
When you! nish this chapter, you should be able to:
- Identify the trade-o" s that! rms must consider when they determine their target
capital structure.- Distinguish between business risk and! nancial risk and explain the e" ects that
debt! nancing has on the! rm’s expected return and risk.- Discuss the analytical framework used when determining the optimal capital
structure.- Discuss capital structure theory and use it to explain why! rms in di" erent indus-
tries tend to have di" erent capital structures.13-1 THE TARGET CAPITAL STRUCTURE
A! rm’s optimal capital structure is de! ned as the structure that would maximize
its stock price. It is useful to analyze the situation and attempt to determine the
optimal structure; but in practice, it is dif! cult to do this with much con! dence. As
a result, in practice, many managers think of the optimal capital structure more as
a range (e.g., from 40% to 50% debt) rather than as a precise number (e.g., 45%).
Other! rms study the situation; reach a conclusion as to the optimal structure; and
then set a target capital structure, such as 45% debt.^1 If the actual debt ratio is sig-
ni! cantly below the target level, management will raise capital by issuing debt,
Optimal Capital
Structure
The capital structure that
maximizes a firm’s stock
price.Optimal Capital
Structure
The capital structure that
maximizes a firm’s stock
price.
Target Capital
Structure
The mix of debt, preferred
stock, and common equity
the firm wants to have.Target Capital
Structure
The mix of debt, preferred
stock, and common equity
the firm wants to have.May 2008, the market capitalization of Kellogg’s equity (which
is the stock price times the number of shares outstanding)
was approximately $19.30 billion. From a market value per-
spective, Kellogg’s debt ratio is only $5.86/($5.86! $19.30) "
23.3%, which is actually conservative and helps explain why
the company has a relatively strong BBB! bond rating.
Kellogg and other companies can finance with debt or
equity. Is one better than the other? If so, should firms
finance with all debt or with all equity? Or if the best solu-
tion is some mix of debt and equity, what is the optimal
mix? As you read this chapter, think about those questions
and consider how you would answer them.P U T T I N G T H I N G S I N P E R S P E C T I V E
Chapter 13 Capital Structure and Leverage 401(^1) A recent study by Graham and Harvey surveyed corporate managers and asked whether their! rms established
a target capital structure. Only 19% of the respondents indicated that their! rm did not have a target capital
structure. Ten percent of the respondents said that they had a strict target debt ratio, 34% indicated that they had
a somewhat tight range for their target debt ratio, and 37% of the respondents indicated that they had a " exible
target. Refer to John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence
from the Field,” Journal of Financial Economics, Volume 60 (May 2001), pp. 187–243.
Two video clips of Steve
Walsh, Assistant Treasurer
at JCPenney, talking about
capital structure are available
at http://fisher.osu.edu/fin/
clips.htm. The first clip on
capital structure discusses the
cost of capital and debt, while
the second clip discusses the
optimal capital structure as
seen by JCPenney relative to
capital structure theory as
seen by Modigliani/Miller.