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Optimal Capital Structure

Jules H. Van Binsbergen

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

John R. Graham

Duke University; NBER

Jie Yang

Georgetown University - McDonough School of Business

April 9, 2011

We study optimal capital structure by first estimating firm-specific cost and benefit functions for debt. The benefit functions are downward sloping reflecting that the incremental value of debt declines as more debt is used. The cost functions are upward sloping, reflecting the rising costs that occur as a firm increases its use of debt. The cost functions vary by firm to reflect the firm’s characteristics such as asset collateral and redeployability, asset size, the book-to-market ratio, profitability, and whether the firm pays dividends.

We use these cost and benefit functions to produce a firm-specific recommendation of the optimal amount of debt that a given company should use. In textbook economics, equilibrium occurs where supply equals demand. Analogously, optimal capital structure occurs where the marginal benefit equals the marginal cost of debt. We illustrate optimal debt choices for specific firms such as Barnes & Noble, Coca-Cola, Six Flags, and Performance Food Group, among others. We also calculate the cost of being underlevered for companies that use too little debt, the cost of being overlevered for companies that use too much debt, and the net benefit of debt usage for those that are correctly levered. Finally, we provide formulas that can be easily used to approximate the cost of debt function, and in turn to determine the optimal amount of debt, for any given firm.

Number of Pages in PDF File: 39

Keywords: capital structure, cost of debt, optimal leverage

JEL Classification: G30, G32

working papers series

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Date posted: January 20, 2011 ; Last revised: September 15, 2013

Suggested Citation

van Binsbergen, Jules H. and Graham, John R. and Yang, Jie, Optimal Capital Structure (April 9, 2011). Available at SSRN: http://ssrn.com/abstract=1743203 or http://dx.doi.org/10.2139/ssrn.1743203

Contact Information

Jules H. Van Binsbergen
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
HOME PAGE: http://www.nber.org/people/jules_vanbinsbergen
John Robert Graham
Duke University ( email )
Box 90120
Durham, NC 27708-0120
United States
919-660-7857 (Phone)
919-660-8030 (Fax)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Jie Yang (Contact Author)
Georgetown University - McDonough School of Business ( email )
3700 O Street, NW
Washington, DC 20057
United States
(202) 687-5497 (Phone)
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References:  11
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