Question

You're the CFO of Axelrod Trucking, a privately held firm whose owner, Joe Axelrod, is interested in selling the company and retiring. He therefore wants to pump up its value by any means possible. Joe read an article about leverage in a business magazine the other day, and has sent you a memo directing that you restructure the firm's capital to the "optimum" in order to maximize the company's value. Prepare a brief response to Joe's memo.

Answer 1

The question is about restructuring the firm in order to maximize the firms' value using the optimal capital structure.

An optimal capital structure is the use of equity and debt in a company's capital structure in the best possible way such that due to the minimized cost of capital, the value of the firm is maximized.
This happens because the cost of debt is generally less than the cost of equity as debt is considered less risky than equity and also the company can get a benefit of tax deduction. However, excessive use of debt caused the equity to become riskier, and hence, the cost of equity increases nullifying the advantage gained due to the low cost of debt.
The proportion of debt and equity in the company's capital structure also depends on the strength of its cash flows. A company with fluctuating cash flows should generally avoid using debt as a major constituent of the capital structure as the obligation of interest payments puts pressure on the cash flows of the company. On the other hand, a company with healthy and more stable cash flows would prefer using debt as it avoids dilution and shows the market that the company is confident about the project.

Also, as per economists Modigliani and Miller, the value of a firm is impacted due to capital structure only in the presence of tax.
So, by increasing the amount of debt in capital structure, the value of a company can be increased as this will lead to reduced cost of capital and the future cash flows will be discounted by a relatively small discounting factor further increasing the present value of the firm and hence, the total value.
However, as explained above, the debt proportion should be kept limited based on the company's operating risks, sales risks, tax situation, corporate governance, industry influences, among other factors in order to not make the company extremely risky which otherwise can impact the value of the firm negatively.