Optimal Capital Structure

This post comes to us from Jules van Binsbergen of the Department of Finance at Northwestern University and Stanford University, John Graham, Professor of Finance at Duke University, and Jie Yang of the Department of Finance at Georgetown University.

In our paper, Optimal Capital Structure, which was recently made publicly available on SSRN, we develop a method that can be used to determine optimal capital structure for any given firm. Being able to make specific, firm-by-firm debt policy recommendations is an important addition to the current state of affairs. Though much progress has been made in capital structure research, traditional approaches neither explicitly separate out the benefits and costs of debt to facilitate estimation optimal debt ratios, nor precisely quantify the cost of suboptimal leverage.

In our approach, we use actual capital structure choices to implicitly back out the cost of debt, where this estimated cost of debt encompasses all the ex ante costs that affect corporate financing choices. All else equal, companies that do not use much debt often face large costs, which translates into a “high” cost of debt curve in our approach. Reassuringly, the costs implied in our analysis are consistent in sign with the costs estimated in other empirical research. With the estimated cost and benefit functions we can determine directional (sign) effects, for example, whether firms with collateral face lower costs of debt (and therefore use more debt). Moreover, with our cost-benefit framework, we can make explicit recommendations about optimal capital structure, estimate the increase in firm value that comes from using the model-recommended amount of debt, and address other issues that are described in the paper.

The first step in our analysis is to estimate firm-specific cost and benefit functions for debt. The benefit functions are downward sloping reflecting that the incremental value of debt declines as more debt is used. The cost functions are upward sloping, reflecting the rising costs that occur as a firm increases its use of debt. The estimated cost functions vary by firm to reflect the firm’s characteristics such as asset collateral and redeployability, asset size, the book-to-market ratio, profitability, and whether the firm pays dividends.

We use these cost and benefit functions to produce a firm-specific recommendation of the optimal amount of debt that a given company should use. In textbook economics, equilibrium occurs where supply equals demand. Analogously, optimal capital structure occurs where the marginal benefit of debt equals the marginal cost of debt, which we can approximate in our approach. We illustrate optimal debt choices for specific firms such as Barnes & Noble, Coca-Cola, Six Flags, and Performance Food Group, among others. We also calculate the cost of being underlevered for companies that use too little debt, the cost of being overlevered for companies that use too much debt, and the net benefit of using debt for those that are correctly levered. Finally, we provide formulas that can be easily used to approximate the cost of debt function, and in turn to determine the optimal amount of debt, for any given firm.

The full paper is available for download here.

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