Is there an Optimal Capital Structure?

There is not a definite answer to this question.

According to the traditional view of capital structure, as the level of gearing increases, the cost of equity also increases and the cost of debt remains constant. This is shown in Figure 1. Although the cost of equity increases, this has an overall effect as a result of the lower cost of debt. The weighted average cost of capital (WACC) falls as gearing increases. Once a certain level of debt (not identified) is reached, then the cost of debt starts to increase because of the gearing risk. Therefore, the continuing increase of both the cost of debt and equity causes the WACC to increase (ICSA, 2009).

Figure 1. Traditional view of capital structure

(ICSA, 2009)

Point A in Figure 1 is associated with the minimum cost of capital. It is the financial managers job to come to the decision of determining the appropriate mix of debt and equity to minimise the WACC.

Theorists such as Modigliani and Miller (M&M) (1958) argued against the traditional view of capital structure and developed a proposition described as the ‘irrelevance of capital structure”. They came to the conclusion that the traditional approach is incorrect and the value of the firm depends on its assets and the operating income that has been derived from them, therefore there is no optimal structure.

There are many criticisms with M&M’s theory:

1.    They assume that the capital market is perfect.

2.    Ignore taxation

3.    Assume WACC remains constant at all levels of gearing

However, in 1961 M&M admitted that corporate tax is necessary in their analysis. This altered their conclusion dramatically. They believed that debt became cheaper, as a result of the tax relief on interest payments. They came to the conclusion that if a firm wishes to reduce its weighted average cost of capital (WACC), then it should borrow as much debt as possible which would lead to an optimal capital structure of 99.99% (Samuels, Wilkes & Brayshaw, 1998).

There are also criticisms with M&M's revised theory:

1.    Company’s capital structures are not almost entirely made up of debt.

2.  Assume perfect capital market- however we live in the real world and companies are     exposed to increased interest payments, which could lead to bankruptcy.

Moreover, changing the capital structure of companies can help to create more shareholder value. For example, Aventura Equities announced capital structure changes including a forward stock split.  The company’s CEO believes that this action creates more liquidity for their shareholders and will give the company better opportunities presented as a result of these actions. Enhancing shareholder value is their main aim, and they believe they can meet this goal by changing their capital structure (OTC Markets, 2014). 

So is there an optimal capital structure? I would say no. Given how risky a business is and depending on the circumstances, the appropriate proportion of debt and equity should be used.