Title: Using Microsoft Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory
Abstract: In this paper, we apply the trade-off theory of capital structure to Microsoft. We use data for bond ratings, bond risk premiums, and levered CAPM betas to compute the cost of equity and the weighted average cost of capital for Microsoft at different debt levels. This study shows the impact of increasing financial leverage on WACC. As financial leverage increases, the WACC decreases until the optimal debt ratio is reached, after which, the WACC begins to rise. At this debt ratio, the value of Microsoft will be maximized. Our results indicate the optimal debt ratio for Microsoft is 37.5 percent. According to the trade-off theory of financial leverage, a firm's weighted average cost of capital (WACC) at first decreases as debt is added to its capital structure due to the tax benefit of acquiring debt. Although a firm's costs of debt and equity at first increase as it raises the proportion of debt in its capital structure, the overall WACC will decrease over this initial range as the tax benefit outweighs the negative impact of the increases in the component costs of the WACC. At a certain level of financial leverage, however, the tax benefit will no longer provide a sufficient advantage to overcome the rising costs of debt and equity. Past a certain debt ratio, the market will demand a yet higher interest rate and cost of equity as the market perceives that the firm's risk of bankruptcy is increasing because of the firm's rising debt load. Consequently, after this point of financial leverage, the firm's WACC begins to increase. At the point where a firm's WACC is minimized, the firm's value is maximized, a relationship which can be demonstrated using simple algebra. In this study, we provide an empirical demonstration of the trade-off theory of financial leverage using Microsoft Corporation, a company that has had no long-term debt in its capital structure since its inception thirty years ago (the capital structure is 100 percent equity) 2 . We show how, in principle, Microsoft Corporation could maximize the firm's value by increasing its financial leverage. Application of the theory involves calculating the firm's weighted average cost of capital under different financial leverage scenarios using actual market information to determine Microsoft's costs of debt and equity as financial leverage increases.
Publication Year: 2010
Publication Date: 2010-01-01
Language: en
Type: article
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Cited By Count: 3
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