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Strategic
decisions & Working Capital (WC)
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Investment
decisions |
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Modes of diversification
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Inter-Organizational relationships
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Others : |
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Long-Term
Financial decisions |
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Investment
analysis and decision |
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Optimal
Financial Structure
Traditional
approach
Does an optimum liability and
equity structure exist, in other words, a combination
of
D/E that would allow a maximization
of the value of the economic assets for the
shareholders? Or, does a totally reliable financial
structure such as the WACC is as low as possible?
According to the traditional approach,
an optimal financial structure does exist, which
will allow the company to maximize its value
through the right amount of debts and financial
leverage. The company minimizes its
WACC, in other words, the
cost of financing.
The cost of debt is lower than
the cost of equity (Kd < Ke) as there is
less risk. From that standpoint, any increase
in debt will reduce the WACC.
However, increasing debts creates
a higher risk for shareholders. The market will
therefore require a higher Ke.
The more the company borrows,
the higher the rate of interest as the risk
increases.
The optimal structure is therefore
one in which the WACC is minimal. At this rate,
the value of the company is maximized.
Example
| D
/ V |
0,00% |
13,33%
|
26,67% |
40,00%
|
53,33% |
66,67% |
80,00% |
93,33% |
Ke |
9,50%
|
10,00%
|
10,50% |
11,40% |
12,50% |
13,00%
|
16,00% |
23,00% |
Kd |
0% |
4,00% |
5,00% |
6,00% |
7,00% |
9,00% |
10,50% |
11,80% |
WACC |
9,50% |
9,20% |
9,03% |
9,24% |
9,57% |
10,33% |
11,60% |
12,55% |
Two ways to
calculate the cost of equity (Ke)
:
Value of the company
:
Value
of the firm =
|
EBIT |
|
| WACC |
Different values of
the firm according to different D/E ratios and
with an EBIT of 1,800 :
| D
/ V |
0,00% |
13,33%
|
26,67% |
40,00%
|
53,33% |
66,67% |
80,00% |
93,33% |
Value |
18 947 |
19 565 |
19
926 |
19 481 |
18 815 |
17 419 |
15 517 |
14 346 |
"Modern"
approach
Source : Franco Modigliani and
Merton Miller : "The cost of capital, corporate
finance and the theory of investment",
American Economic Review (June 1958), pp. 261-277.
According to M & M, and on
the contrary to what has been previously stated,
the traditional approach is incorrect : an optimal
financial structure does not exist. The WACC
is constant, whatever the quantity of debt is.
Two identical companies, with two different
financial structures, have the same economic
value of assets.
As the firm borrows more, the
risk of default increases and the firm is required
to pay higher rates of interest. When this occurs
the rate of increase in Ke slows down. As the
firm borrows more, more of that risk is transferred
from shareholders to bondholders.
Example
D
/ V |
0,00% |
13,33%
|
26,67% |
40,00%
|
53,33% |
66,67% |
80,00% |
93,33% |
Ke |
12,00% |
13,23% |
14,55% |
16,00% |
17,71% |
19,00% |
18,00% |
14,80% |
Kd |
0,00% |
4,00% |
5,00% |
6,00% |
7,00% |
8,50% |
10,50% |
11,80% |
(Ka)WACC |
12,00% |
12,00% |
12,00% |
12,00% |
12,00% |
12,00% |
12,00% |
12,00% |
Formula to calculate
the cost of equity (Ke) :
Ke
= Ka + (D/E).(Ka-Kd)
Constant value of
the company :
| Value
of the firm = |
1,800 |
=
15,000 |
|
0,12 |
From the shareholders point of
view, the best financial structure is 66,67
% Debt and 33,34 % Equity because the return
on Equity is maximum at 19 %.
Sources :
Interpreting and using financial
statements, 1999, Marc Bertonèche,
Ph. D. in Finance from the Northwestern University,
Professor at the Bordeaux University and at
Sciences-PO Paris, Visiting Professor at Harvard
Business School and Oxford University.
Principles of Corporate Finance, 5th edition, Richard A. Brealey & Stewart C. Myers, McGraw-Hill
Corporate
Finance Course, Bernard Jaquier, Professor
in Economics & Finance, Lausanne, Switzerland,2018
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