Capital structure active management : a contingent claim approach

Abstract

The capital structure of a company is one of the most studied and discussed topics in modern Finance, in fact several theories and models have been developed throughout the last half-century to address this subject. This dissertation has as its main objective to define a simple, computationally undemanding and dynamic methodology to establish the actual and future optimal capital structure of any listed company, based on the best available public information and, if done by the company’s management, also private information. The presented methodology builds on: (i) the Trade-off theory on its dynamic approach; (ii) the Weighted Average Cost of Capital (WACC), (iii) the Capital Asset Pricing Model (CAPM) to value the cost of equity; (iv) the Merton’s-KMV model to define the Firm Value and the Firm Volatility; and (v) the Merton’s-KMV model to assess the Cost of Debt. Leveraging on these principles it assumes that the optimal capital structure would be the one that minimizes the company WACC. Moreover, this methodology can also be used to assess and value the differences between the Implicit (Market) Leverage and the Optimal Leverage throughout a predetermined period. Having into consideration this trait and in order to test the methodology 28 listed companies of the S&P500 Index were analyzed from December 1999 until December 2012. From that exercise it was concluded that almost 100% of the analyzed sample could be considered (on average) underleveraged, with direct repercussion on its WACC value (on average approximately 0,5% higher than the optimal), and thus on its total market value (on average a loss of approximately $7B).