Determining the optimal capital structure: a practical contemporary approach

Abstract

Determining an optimal capital structure for a company is a multi‐facetted problem that has challenged and fascinated academics and practitioners for a long time. This study investigates capital structures used in different countries and industries and explores the different theories on capital structure that have been put forward to date. A trade‐off model, incorporating taxes and financial distress costs, is applied to determine the optimal capital structure for three companies listed on the JSE South Africa. One of the conclusions drawn from the results of this analysis is that great care needs to be taken in ensuring the reasonableness of the input data and the valuation model. Secondly, significant amounts of value can be unlocked in moving closer to the optimum level of gearing. Lastly, even when one is using a model such as the one illustrated, it may be preferable to try to operate within an acceptable interval rather than to try to attain the absolute optimum capital structure.

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