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Capital structure decision and the cost of capital

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3. What is meant by "an optimal capital structure of the firm"? Be specific.

Consider three companies: Intel, Alcoa, and McDonalds. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is.

Based on the readings of the Module, and upon reviewing the nature of the operations of the companies including the nature of their customers and products, what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? You should relate your answers to what you wrote in your response to question (3) above. Note that you are not asked to provide specific numbers, just 'low debt ratio', 'medium debt ratio' or 'high debt ratio'. (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)

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Solution Summary

The solution discusses capital structure decision and the cost of capital. Intel, Alcoa and McDonalds is examined.

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First, the capital structure of a firm is the "mix of debt and equity that a company uses to finance its business" (Aggarwal, Harrington, Kobor & Peterson, 2008, p. 117) and operations. The goal of management in deciding this mix is to achieve and maintain a capital structure that minimizes the company's average cost of capital and thus maximizes the firm's value.

Second, the optimal capital structure then is the mix of debt and equity financing that results to the optimal value of the firm. One of the conclusions of the theory of Modigliani and Miller in conjunction with the concepts of taxes, costs of ...

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