Capital Structure Decisions and Maximization of Shareholder Wealth - Financial Management

What is meant by a firm’s optimal capital structure? The optimal capital structure is the mix of debt, preferred stock, and common equity that minimizes the weighted cost to the firm of its employed capital. At the capital structure where the weighted cost of capital is minimized, the total value of the firm’s securities (and, hence, the value of the firm) is maximized. As a result, the minimum -cost capital structure is called the optimal capital structure.

The amount of debt contained in a firm’s optimal capital structure is often referred to as the firm’s debt capacity. The optimal capital structure and, accordingly, the debt capacity of a firm are determined by factors including the business risk of the firm, the tax structure, the extent of potential financial distress (e.g., bankruptcy) and agency costs, and the role played by capital structure policy in providing signals to the capital markets regarding the firm’s performance. Each of these factors is considered in the following sections.

Assumptions of Capital Structure Analysis

The analysis that follows is based on some important assumptions. First, it is assumed that a firm’s investment policy is held constant when we examine the effects of capital structure changes on firm value and particularly on the value of common stock. This assumption means that the level and variability of operating income (EBIT) is not expected to change as changes in capital structure are contemplated. Therefore, capital structure changes affect only the distribution of the operating income between the claims of debt holders, preferred stockholders, and common stockholders.

By assuming a constant investment policy, we also assume that the investments undertaken by the firm do not materially change the debt capacity of the firm. This assumption does not always hold in practice, but for the overwhelming majority of investment projects, it is a realistic assumption that also helps us focus on the key determinants of an optimal capital structure.

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