Question

9. Define the optimal fraction of debt and the growth rate of a firm. What is the relationship between the two?

Answer 1

An optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one that offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility; however, it is rarely the optimal structure since a company's risk generally increases as debt increases.

BREAKING DOWN THE TERM OPTIMAL CAPITAL STRUCTURE

A company's ratio of short- and long-term debt should also be considered when examining its capital structure. Capital structure is most often referred to as a firm's debt-to-equity ratio, which provides insight into how risky a company is for potential investors. Determining an optimal capital structure is a chief requirement of any firm's corporate finance department.

Companies can raise capital with either debt or equity. Each strategy has its own advantages and disadvantages. Debt usually costs less than equity due to tax advantages, especially when rates are low. However, debt also obligates the company to pay out a portion of future earnings, even when earnings are declining. By contrast, equity does not need to be paid back; however, equity comes with an exchange of ownership. Most companies use a mix of both debt and equity to raise capital. This mix is referred to as the capital structure. It is the goal of most public companies to operate at an optimal capital structure to maximize profits.

WAYS TO THINK ABOUT THE CAPITAL STRUCTURE

There are two ways to think about optimal capital structure. One is personal and one is business-related. A chief executive officer (CEO) may not like debt in her personal life; however, her company may require the use of debt to maximize profits. At some point the debt becomes a strain on earnings. Qualitatively, the optimal capital structure lies somewhere between maximum profitability and financial burden.

How to quantify the capital structure

The most popular way analysts measure capital structure is with the debt-to-equity ratio. Some analysts compare it against other companies in the same industry. The assumption is these companies are operating at an optimal capital structure, which is a significant assumption. In this case, an analyst can select a few of the best-performing or high-growth companies in the industry for comparison. The assumption holds but is less significant.

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The default spread attached to the bond rating can then be used for the spread above the risk-free rate of a AAA-rated company.

Relation between optimal fraction of debt also known as leverage here and growth of a firm is as follows

In general, the decisions of capital structure are important. M&M (1958), argue the irrelevance of the financial structure regarding the impact on the firm value, in an "ideal world".

Harris and Raviv (1991) believe that the leverage decreases due to profitability. The pecking-order theory (Myers and Majluf, 1984) maintains that firms with greater profitability require a lower amount of debt since they generate more internal resources to finance investments. By contrast, the trade-off theory suggests a positive relationship between profitability and debt, because the most profitable businesses have a lower probability of financial distress (Fama and French, 2002).

With regard to growth opportunities (as measured by market-to-book ratio or Tobin’s Q), there are divergent arguments regarding the sign of the relationship with leverage. While the arguments of the agency theory imply a negative relationship between growth and leverage (Jensen, 1986), the pecking order theory suggests both a positive and negative relationship. Myers (1977), for example, argues that the relationship is negative, as firms with high growth opportunities are more risky, since they have more volatile earnings and therefore have difficulty accessing low-cost credit. Even Fama and French (2002) maintain that high-growth businesses use less debt. By contrast, Myers (1984) argues that firms with high growth opportunities may use more debt to reduce costs arising from informational asymmetries and to send out a signal to the market with regard to the quality of investments. In empirical terms, while Michaley et al, (2015) found a positive relationship between leverage and growth opportunities, other studies found a negative relationship (e.g. Rajan and Zingales, 1995).