Corporate Finance, 4th Edition

Chapter 32Capital structure and the theory of perfect capital markets

Does paradise exist in the world of finance?

The central question of this chapter (and of the following one) is: is there an optimal capital structure? That is to say, is there a “right” combination of equity and debt that allows us to reduce the weighted average cost of capital and therefore to maximise the value of capital employed (enterprise value) ?

The reader may be surprised by this question when Chapter 13 showed clearly how return on equity could benefit from the leverage effect. But again we recall that we have now left the world of accounting in order to enter the universe of finance.

Jumping directly to the conclusion, this part of the book could be renamed “the uselessness of the leverage effect in finance”!

Note that we consider the weighted average cost of capital (or cost of capital), denoted k, to be the rate of return required by all the company's investors either to buy or to hold its securities. It is the company's cost of financing and the minimum return its investments must generate in the medium term. If not, the company is heading for ruin.

k_D is the rate of return required by lenders of a given company, k_E is the cost of equity required by the company's shareholders, and k is the weighted average rate of the two types of financing, equity and net debt (from now on often referred to simply as debt). The weighting reflects the breakdown of equity and debt in enterprise value.

With V_D