Strategic Corporate Finance: Applications in Valuation and Capital Structure

LESS DEBT IS NOW “OPTIMAL”

Optimal capital structure is a topic of continued academic research and debate. Although the trade-offs between debt and equity are well documented, the over-riding needs of a company and the intangible nature of many of the costs and benefits of leverage have relegated much of the debate to academic quarters. Practitioners tend to make their decisions based on target credit ratings and other factors, albeit with modest consideration to financial theory.

The benefits of debt have been well documented. Debt is the most convenient form of financing that avoids diluting the ownership interest of equity holders while funding growth. Debt service is a tax efficient use of operating cash flows. Financial leverage can reduce your weighted average cost of capital (WACC) by substituting lower cost debt for more expensive equity. Leverage reduces agency costs through increased fiscal discipline, sending a positive signal to the investment community.

The overall WACC function is lower, flatter, and more shifted to the left (Figure 7.2). The WACC, over different target amounts of financial leverage, has changed. The optimal proportion of debt in the composition of a corporation’s capital structure has been steadily reduced since 1998 through the confluence of three factors. A combination of explicit costs and intangible considerations combine to keep the cost of leverage high in a low rate era. Three factors contribute to the reduction in the optimal level of debt ...