Thus, as long as the return on asset exceeds the cost of debt, then the re-
turn on equity rises linearly with leverage.
The Pure Theory of the Optimal Financial Structure
The pure theory of the optimal capital structure is based on the assumption
that the firm is a semimonopsonistic demander of funds from the capital
market. By discriminating against the suppliers of funds through employing
varying debt instruments and judiciously balancing the total of financial
risk and external risks, the firm can achieve an optimum financial structure,
reducing total financing costs and maximizing the value of its shares. The
four parameters constituting the environment in which the firm exists are:
1.The individual firm is confronted by two types of risks. One type we
might call the external risk, while the other type the internal or finan-
cial risk.^2
2.The external risks are a composite of the stability of earnings or cash
flow of the firm, and the liquidity, safety, and marketability of the assets
typically held by the firm. The level of external risk is in large part dic-
tated by the nature of the industry in which the firm is engaged and is
not subject to any great extent to the control of the financial decision
makers. External risk may be referred to as the “degree of operating
leverage,” as it is concerned with the firm’s operating income (Copeland
and Weston 1992).
3.Internal risk is the financial risk of the firm’s capital structure. It is set
by the types of liabilities (short-term or funded) that the firm carries
and the total amounts of the liabilities in proportion to the firm’s eq-
uity capital. The factors constituting the firm’s capital or financial
structure can be varied considerably by the financial management. Fi-
nancial risk is often referred to as the degree of financial leverage
Copeland and Weston 1992. The firm’s (net income) profitability is a
function of its interest payments.
4.The two types of risks together are the sum of the hazards to which the
owners and the creditors of the firm may be subjected. The external risks
are a parameter given by the nature of the industry; these external risks
are borne in mind by both borrowers and lenders and influence the opti-
mum financial risk that different types of firms are likely to carry.The optimum capital structure for any widely held company is one that
maximizes the long-run market value per share of the common stock. This
is not quite the same as asserting that the optimum capital structure is one
that will maximize profit or earnings per share. For both the earnings per
share of stock and the rate at which they are capitalized must be considered.