Optimal Capital Structure: How to Minimize Your Company's Cost of Capital

In our previous article, we discussed how a company's value is decided by the cash flow it generates in the future. However, the cost of capital also plays a critical role. In this article, we will elaborate on how companies can identify optimal capital structure to minimize their Weighted Average Cost of Capital (WACC) and enhance overall value.

Understanding the Cost of Capital

The WACC is a commonly used metric for calculating a company's cost of capital, incorporating both cost of debt and cost of equity. In practice, the cost of debt is obtained by averaging the borrowing rate for all issued debt, while the cost of equity is obtained by using the Capital Asset Pricing Model (CAPM). However, when analyzing? different capital structures, the leverage effect generated by borrowing should also be considered.

Cost of Debt

To calculate the cost of debt under different leverage scales, a common method is to adopt the borrowing rate under different companies' credit ratings. For instance, companies with a rating of AA may be offered a lower borrowing rate like 0.85%, while companies? with a rating of BBB may be offered a higher borrowing rate like 2%.

The interest coverage ratio indicates a company's ability to repay interest payments and is also related to the company's credit rating. Generally, a company with a higher interest coverage ratio indicates that it has a better ability to pay interest, and the higher the company's credit rating. As leverage and interest expense gradually increases, leading to a lower interest coverage ratio and subsequently higher borrowing costs.

Cost of Equity

When calculating Cost of Equity under different leverage scales, we assume the security market line (SML) holds, thereby maintaining the correlation between beta and return. The beta under different leverages can be calculated by adjusting the current beta obtained from CAPM to its new leverage level.

To find beta under different leverage levels, we first find the unlevered beta, where the company is composed without debt. Then, by reversing the equation above,? we use the unlevered beta to acquire beta under different leverage.

What is Capital structure

The term capital structure refers to the proportion of debt and equity the firm uses to finance its business, while optimal capital structure refers to the ratio of debt and equity that minimizes a company's overall cost of capital (WACC). Although in normal scenarios, the cost of debt would be lower than the cost of equities. Hence, by intuition, a firm should raise as much money as it can through borrowings to repurchase all of its outstanding shares.

However, as the leverage gradually increases, cost of debt would increase to infinity. This happens because, with 100% leverage, the company’s equity holders have no investment, leaving lenders to bear all the risk, which no creditor would be willing to do.

Case Study: Optimal Capital Structure for TSMC (2330.TW)

Take TSMC (2330.TW) for example, we calculate the best capital structure for TSMC.

Assumption:

1. EBIT stays the same despite the change in leverage
2. Capital structure is adjusted only with the amount of debt instead of the amount of equity.

First, we acquire the following financial data from TEJPro database.

Later on, we compute the current WACC and find out the levered and unlevered beta by applying CAPM on TSMC’s and the stock market’s historical data.

Next we create a table of borrowing rates for companies with different ratings.

Now we are all set for building our own sheets for calculating the optimal capital structure.

Based on our analysis, the optimal debt ratio (D/A) for TSMC is approximately 25%, leading? to? a WACC around 51%.

Conclusion: Revenue Up and Cost Down

For all companies, there are two simple methods to increase their value, Revenue up and Cost down. While growth companies typically focus on revenue expansion, value companies often shift their focus to cost reduction, especially through optimizing their capital structure. By finding the optimal capital structure, companies can reduce their cost of capital, thus improving profitability.

Leverage the power of TEJPro’s comprehensive financial database to analyze the financial structure of listed companies. TEJPro provides all the data you need for both fundamental and market analysis, ensuring high-quality financial data through rigorous validation and value-added enhancements. TEJ database solution quickly solve your data needs, and efficiently help your decision-making.

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