Question

Make recommendations for optimizing capital structure at AMazon.

Answer 1

An optimal capital structure is the objectively best mix of debt, preferred stock, and common stock 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) 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).

The Modigilani-Miller (M&M) theorem is a capital structure approach named after Franco Modigliani and Merton Miller . Modigliani and Miller were two economics professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. This proposition states that in perfect markets the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. The M&M theorem made two propositions:

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• Proposition I: This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same and value would not be affected by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
• Proposition II: This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available