Question

1 (c) A firm may be unable to undertake all of its wealth-creating projects due to insufficient available funds for investment. What market imperfections might cause this problem? How should the firm identify its optimal capital investment strategy if it faces this problem? (150 words).

Answer 1

Optimal Capital Structure

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

According to economists Modigliani and Miller, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, in an efficient market, the value of a firm is unaffected by its capital structure.

What Are the Best Strategies for Optimal Capital Structure?

Optimal capital structure is the ideal balance between the amount of debt and equity that a firm issues to finance its operations. The goal of a good capital structure strategy is to keep the amount of debt as low as possible while increasing the wealth of shareholders by the maximum amount possible. When a company formulates and executes a strategy, it should consider its risks, expected revenue, managerial style, and possible fluctuations in its revenue and tax rate.

In order to finance growth, companies need an influx of cash. Since capital projects usually require a large up-front investment, companies need to raise funds through an optimal capital structure that may include debt, equity, or both. Debt is typically issued in the form of bonds while equity is issued in the form of preferred and common stock. The main disadvantage of issuing large amounts of debt is that it downgrades the company's credit rating and makes them appear to be a higher investment risk.

A second disadvantage of primarily relying on debt to finance capital projects is that it is costly. Debt typically carries a fixed cost, which means that the cost does not fluctuate with market conditions, sales or the success or failure of the capital project. The value of the bonds issued must be paid back to investors at a specific point in time, making it a less than optimal capital structure strategy. Some issuance of debt is acceptable, but if the company is ever unable to pay back its fixed costs, it might be forced into insolvency.

Equity in the form of preferred and common stock is an important part of an optimal capital structure strategy. Unlike debt, the costs associated with issuing equity are variable as they directly respond to market volatility. Equity helps a company leverage the balance between the risks involved in a capital project and the return that owners and managers expect to receive. When equity is issued, the company receives a value for the stock based upon an initial public offering and gives the investors part ownership in the company.

Should the capital project not meet its expected rate of return, the company only has to pay out the market value of the stock if the investor chooses to sell his shares. That market value may be higher or lower than the value received for the initial public offering. Dividends or profits can be paid to stockholders or they can be retained by the company to further additional projects.

An optimal capital structure usually includes both debt, common stock and preferred stock. The strategy will vary based upon the required rate of return and the company's overall objective. Any capital structure strategy needs to maximize return while minimizing risk. It should also seek to keep the cost of capital at its lowest possible value.