Optimal Capital Structure (OCS) with a Finite Cash Flow: A Simple Numerical Illustration
26 Pages Posted: 28 May 2019
Date Written: May 2, 2019
In this note, we present a simple numerical example, with a finite cash flow, to illustrate the concept of the Optimal Capital Structure (OCS). First, we assume that the discount rate for the tax benefits KTB equals the return to unlevered equity KU. The cost of debt KD is a simple linear function of the percent debt %D and the leverage costs LC are proportional to the percent debt %D. With this stringent assumption about the value of KTB, over the life of the FCF (Free Cash Flow), we obtain constant annual debt-equity ratios D/E; the return to levered equity KE and the FCF WACC are also constant over the three years. The FCF WACC decreases and then increases after the value of the maximum percent debt. We also analyze the cases where the value of KTB equals the cost of debt KD and the return to levered equity KE. We recognize that the risk profile of the tax shields is complex, and it may not be possible to capture all the benefits of the tax savings from debt financing with a single discount rate. Nevertheless, we ignore our own admonitions, and present a model that may have pedagogical value and provide insights for valuation.
Note: I wish to thank Ignacio Velez-Pareja and Rauf Ibragimov for vigorous discussions and comments. I am solely responsible for all errors in the interpretation and understanding of their important, critical and relevant comments and ideas.
Keywords: Optimal Capital Structure (OCS), Financial modeling, Valuation, Weighted Average Cost of Capital (WACC)
JEL Classification: D61, H43, M21, M40, M46, G12, G31, G33
Suggested Citation: Suggested Citation