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Did you know that the way you arrange your company’s financial foundation has direct effects on the market value of the business? A company’s capital structure—the mix of debt and equity financing—does just that and can have long-lasting impacts on the business.
Many companies could improve their market value efficiently by simply funding projects or acquisitions through debt instead of equity. However, there is a limit to the acceptable level of debt. Beyond this limit, financial risk increases and causes the equity shareholders to require higher returns as compensation for this increased risk.
Because of this sliding scale, there is an optimal capital structure for maximizing market value. Do you know how to find the optimal capital structure for your company?
All capital has a cost. Most business owners are familiar with paying interest on debt, either through their personal or business life. That is the cost of debt. But some may not realize that equity has a cost as well.
Instead of calculating the required equity return rate, the founder of a self-funding business might intuitively estimate it. They put energy into building a great product, gaining customers, and creating cash flow. As the business grows and further expansion means considering new funding sources, a decision must be made between funding the project with personal equity or external sources. What percentage return is an acceptable rate on that investment? Taking into account the risk and alternative investment choices, a ballpark figure can be estimated.
In terms of market value, the optimal capital structure definition is where the marginal benefit equals the marginal cost of adding additional debt. In short: taking on more debt beyond the optimal debt ratio can decrease your company’s overall market value because it increases the business’s overall financial risk.
So, how can you calculate the optimal capital budget?
A core aspect of calculating your optimal capital structure is determining the business’s weighted average cost of capital (WACC).
For a simplified example of determining the weighted average cost of capital, imagine a company with a 40/60 debt vs. equity ratio. The 40% debt carries an interest rate of 10%, and the equity shareholders require a 20% return, resulting in a WACC of 16%.
16% WACC = Debt (40% x 10%) + Equity (60% x 20%)
Representing your minimum required rate of return, WACC serves as the discount rate for determining your company’s net present value (NPV) based on future income. In addition to using WACC to assess its market value, companies of all sizes use this rate to help decide if and at what conditions they’ll take on new projects.
Changes to your company’s WACC can heavily influence market value because it changes how quickly your future profits are discounted. A higher cost of capital can equate to a riskier capital structure, which would lower your market value. In a simple optimal capital structure example, if your market value is $1.5 million when WACC is 16%, a decrease to 10% might push your market value to $2.4 million.
In addition to debt’s tax advantages, debt is usually cheaper than equity because the risk is lower as debt holders get paid out first in a liquidation event. On the other hand, equity shareholders require higher rates of return because they are last in line to receive company profits. To determine your company’s target capital structure, you’ll need to pursue the mix of debt and equity that gives the lowest WACC.
One of the most significant limitations of optimal capital structure strategy is that there is no simple optimal capital structure formula. When calculating your optimal capital structure, you can expect a range of options that will vary by industry, type of business, and stage of development.
Higher debt ratios lead to lower WACC, but only to a point. Beyond the sweet spot of the curve, more debt will increase volatility and risk to shareholders. Because of the higher risk, equity shareholders will demand higher returns, further driving up the WACC.
Regulatory changes and interest rates can also impact the acceptable level of debt. Although interest rates are currently low and debt has some tax advantages, it’s essential to regularly revisit the business’s target capital structure.
Optimal capital structure is also difficult to define for very early-stage companies. Without a strong balance sheet or clear profitability trajectories, determining the optimal debt ratio for maximizing a company’s worth can be challenging.
There are two commonly used capital structure theories.
Proposition I: In the late 1950s, Modigliani and Miller established the capital structure irrelevance proposition. In it, they professed that the real value of a company comes from its future earnings, so the capital structure has no impact on the firm’s value. Two identically valued companies would hold the same worth regardless of their debt to equity ratio.
Proposition II: Later in the 1960s, the two revisited their model to admit that the mix of debt vs. equity is indeed important. In the real world, companies pay taxes and face credit risks and inefficient markets, and because of these factors, companies should maximize debt usage.
When considering how to calculate the optimal capital budget formula, this theory encourages companies to prioritize debt or equity-based financing based on the path of least resistance.
Optimal capital structure means maximizing debt to the point just before it starts to increase your WACC. Although many individuals are scared of debt in their personal lives, intelligent use of debt to fund your business’s growth can bring significant advantages.
Achieving the right amount of debt can reduce significant financial risk. Your interest rates and the required monthly payments are transparent in advance.
Finding your optimal debt ratio also helps limit the amount of equity financing necessary and prevents dilution of shareholder value. Overall equity is limited, and selling shares reduces the owner’s stake in the company. Prioritizing debt helps founders and early stakeholders retain a more significant portion of the pie. The hidden advantage of tightly holding equity is that doing so reduces the risk of external shareholders taking over and altering the company’s direction.
Understanding how to find the optimal capital structure for your business can significantly impact its market value. The optimal capital structure may change over time, but it’s the one that gives the lowest cost of capital and thus the highest market value. Where possible, companies should incur debt financing right up until the point that the WACC starts to increase again.