What is the concept of Otimal capital structure?

Question

If you are calculating the cost of equity of the company that is going to appraise a new investment project, which beta value will you use....latest or at the time of its last financial statement or any one else??

Answer 1

You have two very different questions here.

The first is a question about the ratio of debt and equity in a firm. The optimal capital structure is that which maximizes share value.

If you have a profitable company with no debt, you can increase its value by selling some equity and adding debt. This is because interest paid to debtholders is tax deductible -- so these tax savings are passed on to the stock holders -- increasing their value.

So -- why not get as much debt as possible? You don't want to do that because if there is too much debt, the probability of default increases. Since there are dead-weight costs to default, having too much debt decreases the value of the firm (by the probability of default times the deadweight loss). Therefore, you want debt -- but not too much debt. The point at which the costs of bankruptcy cancel out the tax advantage is the optimal capital structure.

The other question is about a project. The beta that you should use is the beta of the project, not the beta of the firm.

If you need the beta of equity for some other reason -- you should use the latest beta -- not the beta at the time of the last statement. Since firms in the US have quarterly statements -- these will usually be close to one another.