What is the optimal capital structure of a company?

 

What is the optimal capital structure of a company?

The optimal capital structure of a company is a combination of debt and equity financing that maximizes the market value of the company by minimizing the cost of the capital. 

However, a hefty amount of debt increases the financial risk to the shareholders, and the return on equity that they need.

What is a change in the working capital of a company?

The difference specified between the working capital for the two reporting periods is specified as the change in working capital. The changes in the working capital are included in cash flow operations because companies usually increase and decrease the current assets and current liabilities for funding their ongoing operations.

Corporate Finance - Effects of Debt on the Capital Structure

Using Greater Amounts of DebtRecall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.

With an increased debt load the following occurs: 
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all. 

In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.

Example:The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.

Answer:At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29

Recall that the minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.

Company vs. Stock ValuationThe value of a company's stock is but one part of the company's total value. The value of a company comprises the total value of the company's capital structure, including debtholders, preferred-equity holders and common-equity holders. Since both debtholders and preferred-equity holders have first rights to a company's value, common-equity holders have last rights to a company value, also known as a "residual value".

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/debt-effects-capital-structure.asp#ixzz1yezxSCbw

Video on WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
Read more: http://www.investopedia.com/video/play/what-is-wacc#ixzz1yfHGTd8N
http://www.investopedia.com/video/play/what-is-wacc#axzz1ybqROWiK

Changes in Capital Structure

The preference for an all-common stock capitalization could in many cases prove disadvantageous for the owners of the business.

Not only might it prevent them from "maximising their gains", but more seriously, it might prevent them from earning enough on their capital to support or carry the investment.

We think there is an unanswerable argument in favour of a moderate amount of senior securities (bonds and preferred shares) if:

• (1) such senior securities might be conservatively created and bought for investment under established standards of safety; and
• (2) the use of senior capital is necessary to provide a satisfactory return on the common equity.

A company with only common stock outstanding may change toward the optimal structure by any of several means:

• 1. It may issue senior securities (bonds and preferred shares) pursuant to an expansion move, perhaps involving the acquisition of another business. (Example: Beaunit Mills Corporation changed from an all-common structure in March 1948 to a predominantly senior-security structure in March 1949.)
• 2. It can recapitalize, and issue new preferred stock and common stock - or even new bonds and common stock - in place of the old common. (Example: Ward Baking Company did this, via a new holding-company setup in 1924.)
• 3. It can declare a stock dividend, payable in new preferred shares. (Example: Electric Boat issued such a stock dividend in 1946.)
• 4. It can sell senior securities (bonds and preferred shares) and distribute all or part of the money to the common stockholders. (Example: In effect this was done in the recapitalization of Maytag Company in 1928.)

When a move of the fourth kind is made, it is almost always tied in with a merger or other corporate development - presumably because financial opinion is prejudiced against the sale of senior securities for cash to be distributed to common shareholders, regardless of the logic in the individual case.

Experience amply shows that once management is persuaded that the capital structure should be changed, to create a better earning power per dollar of common investment, it can readily find suitable means of accomplishing this end.

While this is a matter that may be of considerable importance to the stockholders of many companies, we do not think that they are likely to formulate and express independent views thereon until they have made considerable progress in self-education on other points affecting their interest.

Attention to this matter will repay careful thought by security analysts, managements, and enterprising stockholders.



Ref: Security Analysis by Graham and Dodd