To estimate the optimal mix of debt and equity for your firm and to evaluate the effect on firm value of moving to that mix.

Key Questions

• Based on the cost of capital approach, what is the optimal debt ratio for your firm?

Bringing in reasonable constraints into the decision process, what would your recommended debt ratio be for this firm?

• Does your firm have too much or too little debt

- relative to the industry in which they operate?

- relative to the market?

Framework for Analysis 1. Cost of Capital Approach

• What is the current cost of capital for the firm?

• What happens to the cost of capital as the debt ratio is changed?

• At what debt ratio is the cost of capital minimized and firm value maximized?

(If they are different, explain.)

• What will happen to the firm value if the firm moves to its optimal?

• What will happen to the stock price if the firm moves to the optimal and stockholders are rational?

2. Building Constraints into the Process

• What rating does the company have at the optimal debt ratio? If you were to impose a rating constraint, what would it be? Why? What is the optimal debt ratio with this rating constraint?

• How volatile is the operating income? What is the “normalized” operating income of this firm, and what is the optimal debt ratio of the firm at this level of income?

3. Relative Analysis • Relative to the industry to which this firm belongs, does it have too much or too little in debt? (Do a regression, if necessary.)

• Relative to the rest of the firms in the market, does it have too much or too little in debt? (Use the market regression, if necessary.)
Getting Information about Optimal Capital Structure To get the inputs needed to estimate the optimal capital structure, examine regulatory filings and the annual report. The ratings and interest coverage ratios can be obtained from the ratings agencies (S&P, Moody’s), and default spreads can be estimated by finding traded bonds in each ratings class.
Online sources of information:
www.stern.nyu.edu/~adamodar/cfin2E/project/data.htm