{"id":28725,"date":"2024-10-03T11:21:46","date_gmt":"2024-10-03T03:21:46","guid":{"rendered":"https:\/\/www.tejwin.com\/?post_type=insight&#038;p=28725"},"modified":"2024-10-07T09:48:53","modified_gmt":"2024-10-07T01:48:53","slug":"optimal-capital-structure","status":"publish","type":"insight","link":"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/","title":{"rendered":"Optimal Capital Structure\uff1aHow to Minimize Your Company&#8217;s Cost of Capital"},"content":{"rendered":"\n<figure class=\"wp-block-image size-large is-resized\"><img fetchpriority=\"high\" decoding=\"async\" width=\"1024\" height=\"585\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-1024x585.jpg\" alt=\"Optimal Capital Structure\nThe 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\u00a0 different capital structures, the leverage effect generated by borrowing should also be considered.\" class=\"wp-image-28726\" style=\"width:840px;height:auto\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-1024x585.jpg 1024w, https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-300x171.jpg 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-150x86.jpg 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-768x439.jpg 768w, https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1-1536x878.jpg 1536w, https:\/\/www.tejwin.com\/wp-content\/uploads\/e1517770-c203-455e-9cb6-a965a353374c-1.jpg 1792w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p><a href=\"https:\/\/www.tejwin.com\/en\/insight\/2-common-dcf-valuations-fcff-and-fcfe\/\"><strong>In our previous article<\/strong><\/a>, we discussed how a company\u2019s 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.\u00a0<\/p>\n\n\n\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-hierarchy ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Table of Contents<\/p>\n<label for=\"ez-toc-cssicon-toggle-item-69eb146f66aae\" class=\"ez-toc-cssicon-toggle-label\"><span class=\"ez-toc-cssicon\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #999;color:#999\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #999;color:#999\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/label><input type=\"checkbox\"  id=\"ez-toc-cssicon-toggle-item-69eb146f66aae\"  aria-label=\"Toggle\" \/><nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#Understanding_the_Cost_of_Capital\" >Understanding the Cost of Capital&nbsp;<\/a><ul class='ez-toc-list-level-3' ><li class='ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#Cost_of_Debt\" >Cost of Debt<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#Cost_of_Equity\" >Cost of Equity<\/a><\/li><\/ul><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#What_is_Capital_Structure\" >What is Capital Structure?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#Case_Study_Optimal_Capital_Structure_for_TSMC_2330TW\" >Case Study: Optimal Capital Structure for TSMC (2330.TW)<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/www.tejwin.com\/en\/insight\/optimal-capital-structure\/#Conclusion_Revenue_Up_and_Cost_Down\" >Conclusion: Revenue Up and Cost Down<\/a><\/li><\/ul><\/nav><\/div>\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Understanding_the_Cost_of_Capital\"><\/span>Understanding the Cost of Capital&nbsp;<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The <strong>WACC<\/strong> is a commonly used metric for calculating a company&#8217;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&nbsp; different capital structures, the leverage effect generated by borrowing should also be considered.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Cost_of_Debt\"><\/span>Cost of Debt<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>To calculate the cost of debt under different leverage scales, a common method is to adopt the borrowing rate under different companies&#8217; credit ratings. For instance, companies with a rating of AA may be offered a lower borrowing rate like 0.85%, while companies&nbsp; with a rating of BBB may be offered a higher borrowing rate like 2%.&nbsp;<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"916\" height=\"84\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/q.png\" alt=\"\" class=\"wp-image-28730\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/q.png 916w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-300x28.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-150x14.png 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-768x70.png 768w\" sizes=\"(max-width: 916px) 100vw, 916px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>The interest coverage ratio indicates a company&#8217;s ability to repay interest payments and is also related to the company&#8217;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&#8217;s credit rating. As leverage and interest expense gradually increases, leading to a lower interest coverage ratio and subsequently higher borrowing costs.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Cost_of_Equity\"><\/span>Cost of Equity<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>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 leverage can be calculated by adjusting the current beta obtained from CAPM to its new leverage level.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"434\" height=\"104\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/m.png\" alt=\"\" class=\"wp-image-28732\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/m.png 434w, https:\/\/www.tejwin.com\/wp-content\/uploads\/m-300x72.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/m-150x36.png 150w\" sizes=\"(max-width: 434px) 100vw, 434px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>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,\u00a0 we use the unlevered beta to acquire beta under different leverage.\u00a0<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"What_is_Capital_Structure\"><\/span>What is Capital Structure?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>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&#8217;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.&nbsp;<\/p>\n\n\n\n<p>However, as the leverage gradually increases, cost of debt would increase to infinity. This happens because, with 100% leverage, the company\u2019s equity holders have no investment, leaving lenders to bear all the risk, which no creditor would be willing to do.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Case_Study_Optimal_Capital_Structure_for_TSMC_2330TW\"><\/span>Case Study: Optimal Capital Structure for TSMC (2330.TW)<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Take TSMC (2330.TW) for example, we calculate the best capital structure for TSMC.<\/p>\n\n\n\n<h4 class=\"wp-block-heading\">Assumption:<\/h4>\n\n\n\n<ol class=\"wp-block-list\">\n<li>EBIT stays the same despite the change in leverage<\/li>\n\n\n\n<li>Capital structure is adjusted only with the amount of debt instead of the amount of equity.<\/li>\n<\/ol>\n\n\n\n<p>First, we acquire the following financial data from TEJPro database.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1013\" height=\"574\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/n.png\" alt=\"\" class=\"wp-image-28734\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/n.png 1013w, https:\/\/www.tejwin.com\/wp-content\/uploads\/n-300x170.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/n-150x85.png 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/n-768x435.png 768w\" sizes=\"(max-width: 1013px) 100vw, 1013px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>Later on, we compute the current WACC and find out the levered and unlevered beta by applying CAPM on TSMC\u2019s and the stock market\u2019s historical data.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"623\" height=\"458\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/o.png\" alt=\"\" class=\"wp-image-28736\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/o.png 623w, https:\/\/www.tejwin.com\/wp-content\/uploads\/o-300x221.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/o-150x110.png 150w\" sizes=\"(max-width: 623px) 100vw, 623px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>Next we create a table of borrowing rates for companies with different ratings.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"895\" height=\"684\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/p.png\" alt=\"\" class=\"wp-image-28738\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/p.png 895w, https:\/\/www.tejwin.com\/wp-content\/uploads\/p-300x229.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/p-150x115.png 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/p-768x587.png 768w\" sizes=\"(max-width: 895px) 100vw, 895px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>Now we are all set for building our own sheets for calculating the optimal capital structure.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"282\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-1024x282.png\" alt=\"\" class=\"wp-image-28740\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-1024x282.png 1024w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-300x83.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-150x41.png 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-768x212.png 768w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1-1536x423.png 1536w, https:\/\/www.tejwin.com\/wp-content\/uploads\/q-1.png 1942w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"930\" height=\"591\" src=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/r.png\" alt=\"\" class=\"wp-image-28742\" srcset=\"https:\/\/www.tejwin.com\/wp-content\/uploads\/r.png 930w, https:\/\/www.tejwin.com\/wp-content\/uploads\/r-300x191.png 300w, https:\/\/www.tejwin.com\/wp-content\/uploads\/r-150x95.png 150w, https:\/\/www.tejwin.com\/wp-content\/uploads\/r-768x488.png 768w\" sizes=\"(max-width: 930px) 100vw, 930px\" \/><\/figure>\n\n\n\n<div style=\"height:33px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<p>Based on our analysis, the optimal debt ratio (D\/A) for TSMC is approximately 25%, leading to a WACC of around 51%.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Conclusion_Revenue_Up_and_Cost_Down\"><\/span><a><\/a>Conclusion: Revenue Up and Cost Down<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>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.<\/p>\n\n\n\n<p>Leverage the power of TEJPro\u2019s 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.<br><br>Learn more about <a href=\"https:\/\/www.tejwin.com\/en\/databank-solution\/fundamental-data\/\"><strong>TEJ database solution<\/strong><\/a> <\/p>\n\n\n\n<p>or<a href=\"https:\/\/www.tejwin.com\/en\/contact\/\"><strong> Contact us for a demo<\/strong><\/a><\/p>\n\n\n\n<p><\/p>\n","protected":false},"excerpt":{"rendered":"<p>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.<\/p>\n","protected":false},"featured_media":28726,"template":"","tags":[3033,3199],"insight-category":[],"class_list":["post-28725","insight","type-insight","status-publish","has-post-thumbnail","hentry","tag-company-financial-statements-data","tag-tej-database"],"acf":[],"_links":{"self":[{"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/insight\/28725","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/insight"}],"about":[{"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/types\/insight"}],"version-history":[{"count":2,"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/insight\/28725\/revisions"}],"predecessor-version":[{"id":28809,"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/insight\/28725\/revisions\/28809"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/media\/28726"}],"wp:attachment":[{"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/media?parent=28725"}],"wp:term":[{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/tags?post=28725"},{"taxonomy":"insight-category","embeddable":true,"href":"https:\/\/www.tejwin.com\/en\/wp-json\/wp\/v2\/insight-category?post=28725"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}