Session 18: The Cost of Capital Approach to Optimizing Financing Mix

In this class, we continued our discussion of the cost of capital approach to deriving an optimal financing mix: the optimal one is the debt ratio that minimizes the cost of capital. To estimate the cost of capital at different debt ratios, we estimated the levered beta/ cost of equity at each debt ratio first and then the interest coverage ratio/synthetic rating/cost of debt at each debt ratio, taking care to ensure that if the interest expenses exceeded the operating income, tax benefits would be lost. The optimal debt ratio is the point at which your cost of capital is minimized. Using this approach, we estimated optimal debt ratios for Disney (40%), Tata Motors (20%), Vale (30% with actual earnings, 50% with normalized earnings). Disney was underlevered and Tata Motors was over levered.

[ajayshah]

Why can’t you just use the risk free rate in the first approach instead of looking at the incremental approach and using enterprise value as a proxy?