An Empirical Model of Optimal Capital Structure

28 Pages Posted: 22 Dec 2011

See all articles by Jules H. van Binsbergen

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: Fall 2011

Abstract

The authors provide a reasonably user‐friendly and intuitive model for arriving at a company's optimal, or value‐maximizing, leverage ratio that is based on the estimation of company‐specific cost and benefit functions for debt financing. The benefit functions are downward‐sloping, reflecting the drop in the incremental value of debt with increases in the amount used. The cost functions are upward‐sloping, reflecting the increase in costs associated with increases in leverage. The cost functions vary among companies in ways that reflect differences in corporate characteristics such as size, profitability, dividend policy, book‐to‐market ratio, and asset collateral and redeployability. The authors use these cost and benefit functions to produce an estimate of a company's optimal amount of debt. Just as equilibrium in economics textbooks occurs where supply equals demand, optimal capital structure occurs at the point where the marginal benefit of debt equals the marginal cost. The article illustrates optimal debt choices for companies such as Barnes & Noble, Coca‐Cola, Six Flags, and Performance Food Group. The authors also estimate the net benefit of debt usage (in terms of the increase in firm or enterprise value) for companies that are optimally levered, as well as the net cost of being underleveraged for companies with too little debt, and the cost of overleveraging for companies with too much. One critical insight of the model is that the costs associated with overleveraging appear to be significantly higher, at least for some companies, than the costs of being underleveraged.

Suggested Citation

van Binsbergen, Jules H. and Graham, John Robert and Yang, Jie, An Empirical Model of Optimal Capital Structure (Fall 2011). Journal of Applied Corporate Finance, Vol. 23, Issue 4, pp. 34-59, 2011. Available at SSRN: https://ssrn.com/abstract=1975682 or http://dx.doi.org/10.1111/j.1745-6622.2011.00351.x

Jules H. Van Binsbergen (Contact Author)

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

Board of Governors of the Federal Reserve System ( email )

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

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