Optimal Capital Structure

39 Pages Posted: 20 Jan 2011 Last revised: 15 Sep 2013

Jules H. van Binsbergen

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)

John R. Graham

Duke University; National Bureau of Economic Research (NBER)

Jie Yang

Board of Governors of the Federal Reserve System

Date Written: April 9, 2011

Abstract

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.

Keywords: capital structure, cost of debt, optimal leverage

JEL Classification: G30, G32

Suggested Citation

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

Jules H. Van Binsbergen

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
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)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jie Yang (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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