7.8 Optimal Capital Structure (Last Minute Thoughts)
The “Optimal Capital Structure,” which is represented by its debt ratio, i.e., Debt ÷ Net worth or Debt ÷ Total Assets (i.e., Debt/NW or Debt/TA), is that which results in the lowest possible WACC, given certain constraints. As debt increases, so too does its cost. What factors, or constraints, affect the optimal structure?
- Management’s Risk Profile
Some managements are more or less prone to take on risk. It is a matter of personality. The matching concept provides some insight into this matter. Risk profile will affect capital structure and other things.
- Shareholder Risk Profile
Shareholders are also individuals with varying tolerances for risk-taking. Shareholders, by one argument, will appoint management and directors who share their own risk-taking proclivities. Absent that possibility, shareholders may sell shares should the firm’s risk characteristics not match up with their own. (This, of course, disagrees with the notion of “homemade leverage.”)
- Industry characteristics
Some industries have lesser or greater tolerance for risk-taking. For instance, traditionally electric utilities have had high levels of debt and aggressive debt ratios. This is because debt is required for the financing of utilities’ enormous infrastructure – power plants. At the same time, utility revenues are quite stable, given its captive consumer base. Customers must purchase and pay for electricity. Competition is low. Therefore,the times interest earned ratio or “TIE Ratio” (EBIT ÷ Interest Expense) can be low, without seriously risking default. You will recall that the TIE Ratio notes whether there are sufficient operating earnings (EBIT) with which to pay interest on the debt.
- Relative capital costs in the market
While debt is clearly the cheapest source of capital, relative capital costs vary over time, and companies may choose to issue, say stock, when the cost of equity is cheap. It is not unusual therefore to see lots of new stocks issuances when the stock market is high.
Further, while it is necessary for a company to issue both debt and equity at the same time in order to preserve its leverage ratios’ status quo, companies virtually never issue both at once. Instead they opt to issue one or the other, followed sometime later by the capital component not issued earlier.