Optimal capital structure
Optimal capital structure is the debt-to-equity mix that maximises a firm's value, balancing the tax savings from debt against rising expected bankruptcy and agency costs, per trade-off theory.
See it move
An unlevered firm worth €50,000,000 gains a €5,000,000 tax shield from €20,000,000 of debt, less €1,500,000 of expected distress costs, reaching €53,500,000. That is the peak: €10m of debt gives only €52.0m, and €30m of debt falls to €51.5m as distress costs outpace the tax shield.
The formula
Variables
- Value of the levered firm (€)
- Value of the unlevered firm (€)
- Present value of the interest tax shield (€)
- Present value of expected financial distress (bankruptcy) costs (€)
The debt level that maximises this expression is the firm's optimal capital structure under trade-off theory.
Check yourself
A firm's assets have an unlevered value of €40,000,000. Its finance team has estimated the present value of the interest tax shield and the present value of expected financial distress costs for three financing plans: Plan A carries €10,000,000 of debt with a €2,000,000 tax shield and €400,000 of expected distress costs. Plan B carries €25,000,000 of debt with a €5,000,000 tax shield and €1,200,000 of expected distress costs. Plan C carries €40,000,000 of debt with an €8,000,000 tax shield and €6,500,000 of expected distress costs. Which plan gives the firm's optimal capital structure?