Does an Optimal Capital Structure Exist?

Companies can raise capital through debt or equity or a combination of the two each having its different costs with equity a higher risk therefore demand higher returns, and debt a lower risk so lower cost and cheaper. The WACC calculation suggests an optimal capital structure exists and if so then it would be in the company’s best interests to move towards this optimal capital structure in order to increase shareholder wealth. The traditional view is that since debt is cheaper than equity, as lenders require a lower rate of return than ordinary shareholders, debt interest can be offset against pre-tax profits. As dividends are tax deductable and transsaction costs for debt is less than issuing shares then it would seem to suggest that a company should take on more debt. This would increase their gearing level in order for a lower WACC which would reduce the overall cost of finance.
 

However it is not that simple as a higher gearing level coincides with higher risks of financial distress. Too much debt and capital structure influences the business prospects as interest on the debt needs to be paid whether a profit was made that year or not. Furthermore the cost of capital and firms prospects depend on market values and they can fluctuate depending on whether investors believe it to be a success or whether it will fail to achieve the expected cash flows or is a riskier investment that initially thought. Therefore high gearing would benefit the company with a lower WACC, but also brings increased risks to the company’s shareholders which can also end up increasing the WACC through increased cost of equity as shareholders demand more returns as compensation the risk the increased debt holds. This defeats the aim that gearing is to increase shareholder wealth as how the shareholder perceives the high risk from increased debt can destroy value.

 

   IBM is an example of a company that uses a mix of debt and equity to achieve a low WACC:

However if they raise their level of debt and decrease the equity then their WACC is reduced, but this may cause the amount of debt to be a concern to their shareholders 

On the other hand Modigliani and Miller (1958) developed a theory that argued the capital structure of a firm does not have an impact on WACC and the overall value of the firm is constant and shareholder wealth cannot be enhanced by altering the debt to equity ratio therefore no optimal capital structure exists. Their theory however was based on some major assumptions that required the firm to operate in a perfect market of perfect knowledge, that individual shareholders can borrow and lend as cheaply as corporations and in which there is no taxation and financial distress does not exist. These assumptions don’t relate to the real business world so it is hard to believe based on their theory that an optimal structure doesn't exist.

In 1963 Modigliani and Miller revised their previous research to take tax into account; this adjustment dramatically changed their theory as debt has the major benefit of being a tax deductible expense which can be offset against profit. This new theory suggested that the best gearing level for a firm interested in shareholder wealth maximisation is the higher the better, but in practice extreme positions are avoided and companies should borrow to a ‘reasonable’ level however this level can be perceived differently by different businesses. This reasonable level has also changed as market sentiment has come about  in 2007/2008 after the recession, and is assessed based on individual circumstances and now the market has changed shareholders have changed their perception of debt as they have seen how irresponsible lending has damaged the economy and destroyed so many businesses.
 

Miller (1977) also included financial distress in their studies which concluded that WACC goes up at the end therefore relates back to the traditional view but had no conceptual basis for this so proved that an optimal capital structure does exist.

The recent recession as a result from the credit crunch supports the importance of capital structure as it was a result of banks, individual and businesses lending irresponsibly and not being able to repay their debts. Therefore banks are the only industry in the world where the government specifies target leverage ratios and from the recession central banks in 27 countries have took the initiative to  release the Basel III agreement to strengthen the capital requirement for banks further as the current ratio set by the government clearly didn't work. The main requirement for this agreement would mean that banks will have to hold 7% of their assets against their debts, which currently is 2%. However will this be enough to prevent another crisis and slow the growth of the banks, with others suggesting that to bring down bank leverage, all capital regulation should be abolished in order to put shareholder wealth maximisation at the forefront of the business and not in meeting these targets.

Theory has concluded that an optimal capital structure may exist however in practice it is more likely that a range of capital structures exists in which a company can minimise its WACC rather that one particular ratio of debt to equity finance. It would seem that a company that integrates sensible and affordable levels of debt into its capital structure can enjoy the tax advantages, arising from debt finance and as a result reduce its WACC, as long as it doesn't increase its gearing levels to a level that would give a cause of concern to its shareholders.