What is the optimal mix of debt and equity for a firm to maximise the value?

1. Nuances of Debt Vs Equity
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2. A SINGLE STOP FOR MANAGEMENT STUDENTS
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3. If the goal of the management of the
firm is to make the firm as valuable as
possible, then the firm should pick the
debt-equity ratio that makes the pie as
big as possible. The value of a firm is
defined to be the sum of the value of
the firm’s debt and the firm’s equity.
V=B+S
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4. A firm’s capital structure is the relative
proportions of debt, equity, and other
securities that a firm has outstanding.
 What is the optimal Capital Structure?
 The value of the firm equals the market
value of the debt plus the market value of
the equity (firm value identity). This is just V
= D + E. When the market value of debt is
given and constant, any change in the value
of the firm results in an identical change in
the value of the equity.

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5. Why exactly should stockholders care about
maximizing firm value? Rationally, they
should be interested in maximizing
shareholder value.
 The “optimal” or “target” capital structure
is that debt/equity mix that simultaneously
(a) maximizes the value of the firm, (b)
minimizes the weighted average cost of
capital, and (c) maximizes the market value
of the common stock.

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6. How does leverage affect the EPS and ROE of
a firm? When we increase the amount of debt
financing, we increase the fixed interest
expense. If we have a really good year, then
we pay our fixed cost and we have more left
over for our stockholders.
 If we have a really bad year, we still have to
pay our fixed costs and we have less left over
for our stockholders.

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7. 
Modigliani and Miller (MM) developed a theory of Capital
Structure. They received the Nobel Prize in Economics in
1990.

MM Assumptions:
1.Capital markets are frictionless.
2.Firms and individuals can borrow and lend at the risk-free
rate.
3.There are no costs to bankruptcy
4.Firms issue two types of claims: risk-free debt and risky
equity.
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8. 5.All firms are assumed to be in the same risk
class.
6.Corporate and personal taxes are zero.
7.All cash flow streams are perpetuities (i.e.,
no growth).
8.Corporate insiders and outsiders have the
same information (i.e., no signaling
opportunities).
9.Managers always maximize shareholders’
wealth (i.e., no agency costs).
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9. Invest in projects that yield a return greater
than the minimum acceptable hurdle rate.
 Choose a financing mix that minimizes the
hurdle rate and matches the assets being
financed.
 If there are not enough investments that
earn the hurdle rate, return the cash to
stockholders.
 Hurdle rate is the minimum accepatable rate
of return on a project or investment.

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10. In traditional corporate finance, the
objective in decision making is to maximize
the value of the firm.
 A narrower objective is to maximize
stockholder wealth. When the stock is traded
and markets are viewed to be efficient, the
objective is to maximize the stock price.
 All other goals of the firm are intermediate
ones leading to firm value maximization, or
operate as constraints on firm value
maximization.

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11. Firms can always focus on a different objective
function. Examples would include
• maximizing earnings
• maximizing revenues
• maximizing firm size
• maximizing market share
• maximizing EVA
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12. Debt may be in the from of bonds, loans or
commercial paper.
 The objective in designing debt is to make
the cash flows on debt issues match up as
closely as possible with the cash flows that
the firm makes on its assets.
 By doing so, we reduce our risk of default,
increase debt capacity and increase firm
value.

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13. The Debt to Equity ratio is calculated by
dividing total liabilities by total equity. This
gives a measure of how much of the
company’s worth is funded through debt and
how much is funded through equity (i.e.
shareholders, owner’s equity etc.)
 A high Debt to Equity (greater than 1) means
a high percentage of debt funding. This is not
necessarily bad – but does mean that interest
payments will be necessary to repay the
loan. The company should make sure that
funds are available to cover the interest
repayments.

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14. Debt-Equity Formula
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Example

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