A Generalised Procedure for Locating the Optimal Capital Structure

Ruben D. Cohen Presents a generalization of an earlier approach for determining and locating the optimal capital structure of a corporate firm. The approach is the "maximumvalue" methodology and the generalization extends the original problem to one where the firm loses flexibility because of constraints and, therefore, has to move along a specific value-vs-leverage path to get to the optimal capital structure.

The fundamental concepts that shape modern capital structuring theory were first put together by Modigliani and Miller [M&M] (1958) in a series of propositions. These propositions have, for many years, dominated the thought process by which firms choose their leverage ratio to enhance value. Moreover, the appeal that these concepts have had to academics is enormous, as they are open ended and highly controversial.

A major contribution of M&M’s propositions is that they allow one to select, via a formalised process, the right balance between debt, equity and assets that raises the overall value of a firm [i.e. firm’s value, FV]. This increase is brought on by the interest tax shield, which enables FV to grow indefinitely with leverage. The negative impact of leverage was later added to demonstrate that FV reaches a maximum before it begins to fall, owing to the rising cost of debt overtaking the positive attributes of the tax shield. Thus, what this combination produces is a unique optimal capital structure, where FV is at its peak.

Unfortunately, things are not so simple in real life, as evidenced by the large number of studies on how firms generally tend to optimise their capital structure.

Logged-in members can download the article by clicking the link below. To log in or register visit here.

110620_cohen