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University of San Jose-Recoletos

Magallanes St. Cebu City

A Research and Insight Paper on the


Optimal Capital Structure Decisions

In fulfillment of the Midterm requirements in


Accounting 13 Managerial Accounting II

Submitted to
Earlie Edelwise M. Uy
February 16, 2015

Group No. 1
Cabaluna, Nathallie
Gregorio, Alyssa Jane
Maglinte, Liezel Gail
Montes, Jane Belle
Saberon, Emierose
Singson, Kris Anne
Ypil, Ma. Teresa

I.

Introduction
Because capital budgeting decisions impact the firm for several years, they must be
carefully planned.
Capital budgeting refers to the process we use to make decisions concerning investments in
the long-term assets of the firm. The general idea is that the capital, or long-term funds, raised
by the firms are used to invest in assets that will enable the firm to generate revenues several
years into the future. Often the funds raised to invest in such assets are not unrestricted, or
infinitely available; thus the firm must budget how these funds are invested.
It is also known as Investment Decision Making or Capital Expenditure Decisions and 1a
long-term planning for making and financing proposed capital outlays.
Because capital budgeting decisions impact the firm for several years, they must be
carefully planned. A bad decision can have a significant effect on the firms future operations. In
addition, the timing of the decisions is important. Many capital budgeting projects take years to
implement. If firms do not plan accordingly, they might find that the timing of the capital
budgeting decision is too late, thus costly with respect to competition. Decisions that are made
too early can also be problematic because capital budgeting projects generally are very large
investments, thus early decisions might generate unnecessary costs for the firm.
Ideas for capital budgeting projects usually are generated by employees, customers,
suppliers, and so forth, and are based on the needs and experiences of the firm and of these
groups. For example, a sales representative might continue to hear from some of his or her
customers that there is a need for products with particular characteristics that the firms existing
products do not possess. The sales representative presents the idea to management, who in
turn evaluates the viability of the idea by consulting with engineers, production personnel, and
perhaps by conducting a feasibility study. After the idea is confirmed to be viable in the sense it
is saleable to customers, the financial manager must conduct a capital budgeting analysis to
ensure the project will be beneficial to the firm with respect to its value.
In other words, capital budgeting is the decision making process by which a firm
evaluates the purchase of major fixed assets including building, machinery and equipment.
According to John J. Hampton, Capital budgeting is concerned with the firm's formal process
for the acquisition and investment of capital 2. From the above definitions, it may be concluded
that capital budgeting relates to the evaluation of several alternative capital projects for the
purpose of assessing those which have the highest rate of return on investment.

1 Charles Horngren definition


2 Financial Management pp 5.2

II.

The Optimal Capital Structure


First of all, the optimal capital structure is referred to as the mix of debt, preferred stock,

and common equity which maximizes a firms return on capital, thus likewise maximizes the
firms value. In short, the optimal capital structure is the best debt-to-equity ratio for a firm which
would maximize its value.
We can say that a companys capital structure is already at its optimal state when it
portrays an ideal balance of the debt and equity in order to emit its potential maximum capital.
Determining an optimal capital structure is achieved also through minimizing the companys
weighted-average cost of capital. And generally, to reach the optimal capital structure, one
should find the right corporate financing mix.
In the process of reaching an optimal capital structure, the firm should first analyze the
benefits derived from debt against benefits derived from equity. Such analysis may be done
through reviewing the table below:
DEBT
Fixed Claim
High Priority on cash flows
Tax Deductible
Fixed Maturity
No Management Control

EQUITY
Residual Claim
Lowest Priority on cash flows
Not Tax Deductible
Infinite Life
Management Control

For added information, there are also approaches in searching for an optimal financing mix,
these are as follows:

The Operating Income Approach: In this approach, the optimal debt for a firm is
chosen to ensure that the probability that the firm will default does not exceed a

management-specified limit.
The Cost of Capital Approach: In this approach, the optimal debt ratio is chosen to
minimize cost of capital, if operating cash flows are unaffected by financing mix, or to

maximize firm value.


The Adjusted Present Value Approach: In this approach, the effect of adding debt to

firm value is evaluated by measuring both the tax benefits and the bankruptcy costs.
The Return Differential Approach: In this approach, the debt ratio is chosen to

maximize the difference between ROE and cost of equity.


The Comparable Approach: The debt ratio is chosen by looking at how comparable
firms are funded.

In a survey of Chief Financial Officers of large U.S. companies, the following data are provided
for the factors that they considered important in the financing decisions:
FACTOR
Maintain financial flexibility
Ensure long-term survival
Maintain predictable source of funds
Maximize stock price
Maintain financial independence
Maintain high debt rating

RANKING
4.55
4.55
4.05
3.99
3.88
3.56

Maintain comparability with peer group

2.47

To answer the inquiry pertaining to how firms set their financing mix, there are generally three
ways being used. These are the following:

Life Cycle reflects where they are in the life cycle; start-up firms use more equity and

mature firms use more debt.


Comparable Firms firms that choose a debt ratio that is similar to that used by

comparable firms in the same business line.


Financing Hierarchy it uses retained earnings being the most preferred choice in the
type of financing used.

Operating leverage affects the capital structure through its effect on a firms business risk. As
defined, operating leverage is the use of fixed costs rather than the use of variable costs. Thus,
if most costs are fixed, such are not affected when demand decreases. Furthermore, a high
degree of operating leverage implies that a relatively small change in sales results in a large
change in return on equity.
On the other hand, financial leverage is the extent to which fixed-income securities, such
as debt and preferred stock, are used in a firms capital structure.

Bibliography
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