Define different Debt-to-Equity (D/E) ratio scenarios and their corresponding Costs of Equity (Re) and Debt (Rd).
This value is used to scale the debt and equity components for calculating their market values (D and E) for each D/E ratio scenario, providing a proportional firm value for comparison.
Capital Structure Scenarios
Add rows to define different Debt-to-Equity (D/E) ratios and their estimated costs of equity (Re) and debt (Rd). Re and Rd typically change as D/E changes.
D/E Ratio
Cost of Equity (Re %)
Cost of Debt (Rd %)
Actions
Optimization Results
Enter inputs and click 'Calculate Optimal Capital Structure' to see results.
Optimal Capital Structure
Optimal Debt-to-Equity Ratio:
Minimum WACC:
Associated Firm Value:
WACC vs. Debt-to-Equity Ratio
About This Model
This model is designed to help analyze and optimize a company's capital structure by determining the mix of debt and equity that minimizes the Weighted Average Cost of Capital (WACC), thereby maximizing firm value.
**Key Concepts:**
**Capital Structure:** Refers to the specific mix of debt and equity used to finance a company's assets. A company's capital structure is a critical factor in determining its overall cost of capital and its market value.
**Weighted Average Cost of Capital (WACC):** Represents the average rate of return a company expects to pay to its investors (both debt and equity holders). It's the minimum return a company must earn on an existing asset base to satisfy its creditors and shareholders.
$$ WACC = \left(\frac{E}{V} \times Re\right) + \left(\frac{D}{V} \times Rd \times (1 - T)\right) $$
Where:
$E$: Market Value of Equity
$D$: Market Value of Debt
$V$: Total Market Value of the Firm ($V = E + D$)
$Re$: Cost of Equity (Return required by equity investors)
$Rd$: Cost of Debt (Return required by debt investors)
$T$: Corporate Tax Rate (Debt interest payments are tax-deductible, providing a tax shield)
**Optimal Capital Structure:** The specific mix of debt and equity that minimizes WACC, which theoretically corresponds to the maximization of the firm's value. Initially, as debt increases, WACC may fall due to the tax shield and lower cost of debt compared to equity. However, beyond a certain point, the financial risk associated with higher debt increases, driving up both the cost of equity and debt, leading to an increase in WACC.
**Debt-to-Equity (D/E) Ratio:** A financial leverage ratio that indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.
**How this Model Works:**
This model allows you to explore different Debt-to-Equity ratios. For each ratio, you input the corresponding estimated Cost of Equity (Re) and Cost of Debt (Rd). The model then calculates the WACC for each scenario. The scenario with the lowest WACC indicates the optimal capital structure. A base firm value is used to proportionally calculate the market value of equity and debt for each D/E ratio, enabling a consistent comparison of firm value, even though the primary optimization is based on WACC.
**Disclaimer:** This tool provides a simplified simulation for educational and illustrative purposes. Real-world capital structure decisions involve complex factors including industry norms, business risk, financial flexibility, market conditions, and investor perception. Always consult with qualified financial professionals for critical financial decisions.
