Video Transcript: "Ideal Capital Structure"

Now let's talk about why I had originally drawn at that upper level with the highest cost of funds being those that you got out of the capital markets. The bond and initial stock offering rate. And [Part of this is? Partly is?] an explanation on how ideally that's what it's going to look like, but it doesn't always quite get there. It's actually a balancing process, trying to find the most efficient capital structure. And the diagram here should help out a little bit. What I'm doing is I'm measuring here on the horizontal axis the debt ratio. So, the debt ratio starts off on the left at zero and extends up to one on the right. And, I've got two functions right here. I've got this red function which shows the relationship between the debt ratio and the bond rate. And I also have this blue function, which shows the relationship between the dividend rate and the debt ratio.

And let's talk about this bond rate relationship that we have right here. The idea is that as the amount of debt that you've taken out in order to buy your assets increases and increases and increases, any additional loans that you try to make — in other words, more bonds that you try to sell — are viewed as being riskier and riskier and riskier. And so you have to offer higher and higher and higher interest rates in order to make them palatable to people, so they'll actually be willing to buy it. And, so, again, it's just saying that as you issue more debt, you have to pay higher and higher and higher interest rates for people to actually give you that money — in order for them to loan you that money.

The relationship between the dividend rate, which is what people expect to get when they purchase a share of stock, is something which is really really high for low debt ratios, because they expect to get a lot of bang for their buck, and then it declines over as the debt ratio starts to increase. In otherwords, they're hoping to get more leverage and they're willing to go ahead and receive some lower dividend rates if they can leverage their money a little bit — basically, buy a larger firm for each dollar.

And, what you should see is that if you have a debt ratio for this particular firm that's something over here, like this vertical line, something that's a relatively low debt ratio. What you're seeing is that the dividend rate, which is effectively the interest rate you have to pay when you issue new stock, is higher than the interest rate on bonds, and if your debt ratio looks something like that you should say to yourself, "well, clearly I should go ahead and issue more bonds," because that's the cheap way of acquiring some additional money in order to invest it.

And, when you sell more bonds, what happens is that your debt ratio goes up a little bit, because whatever new assets you purchased with that money that you just borrowed is going to be with the debt and it's going to increase your debt ratio. And, again, if you have a debt ratio that's that little bit higher after you made the issuance of bonds, you again see that the cheap money is going to be issuing new bonds.

Well, that's going to keep on happening until you reach this point where these lines right here cross, and that's at this specific debt ratio that I'm just going to go ahead and mark with yellow. And that is effectively where the lines cross here: your ideal capital structure, t is the debt ratio that makes it so that you know for sure that you're minimizing your cost of funds. If your debt ratio is a little bit higher, which you'd notice that it would be easier for you to go ahead and issue new stock in order to get new money. And so, basically, what you're saying is is that there is this ideal debt ratio. And you can tell it is ideal because the cost of acquiring money through the bond markets (selling new bonds) is approximately the same as it would cost you to issue new stocks. Now, what that debt ratio is, really is going to depend upon what industry that you're in. And it has to do with the variability of the net income. And what you're going to find out is that firms that are in industries that have usually very variable net income tend to have higher debt ratios, because people like to have the stability. Firms that are in industries that have net income which is rock steady over the seasons, rock steady over the business cycles, tend to have lower debt ratios, because people don't see the difference between bonds and a share of stock as being all that different in terms of the cash flow that you receive on it.

And so this is the story while in the ideal case your cost of funds through issuing bonds and cost of funds through issuing stock are supposed to be approximately the same, remember it's not always quite there. You're always in the process of making adjustments to get that capital structure right, that debt ratio right, and then make it so that the cost of the funds you're gathering in order to…

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