The Handbook of Corporate Financial Risk Management (2nd Edition)
First published:
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Optimal Leverage
Optimal Leverage
Foreword
Introduction
Theory and Practice of Corporate Risk Management
Theory and Practice of Optimal Capital Structure
Introduction to Funding and Capital Structure
How to Obtain a Credit Rating
Refinancing Risk and Optimal Debt Maturity
Optimal Cash Position
Optimal Leverage
Introduction to Interest Rate and Inflation Risks
How to Develop an Interest Rate Risk Management Policy
How to Improve Your Fixed-Floating Mix and Duration
Interest Rates: The Most Efficient Hedging Product
Do You Need Inflation-linked Debt?
Prehedging Interest Rate Risk
Pension Fund Asset and Liability Management
Introduction to Currency Risk
How to Develop Currency Risk Management Policy
Translation or Transaction: Netting Currency Risks
Early Warning Signals
How to Hedge High Carry Currencies
Currency Risk on Covenants
Optimal Currency Composition of Debt 1: Protect Book Value
Optimal Currency Composition of Debt 2: Protect Leverage
Cyclicality of Currencies and Use of Options to Manage Credit Utilisation
Managing the Depegging Risk
Currency Risk in Luxury Goods
Introduction to Credit Risk
Counterparty Risk Methodology
Counterparty Risk Protection
Optimal Deposit Composition
Prehedging Credit Risk
xVA Optimisation
Introduction to M&A-related Risks
Risk Management for M&A
Deal-contingent Hedging
Introduction to Commodity Risk
Managing Commodity-linked Revenues and Currency Risk
Managing Commodity-linked Costs and Currency Risk
Commodity Input and Resulting Currency Risk
Offsetting Carbon Emissions
Introduction to Equity Risk
Hedging Dilution Risk
Hedging Deferred Compensation
Stake-building
INTRODUCTION
In this chapter, we continue the discussion of Petrol and focus on determining their optimal leverage. The starting point for our analysis is the trade-off theory, which was described in Chapter 2. The main idea of the trade-off theory is to find the optimal point where the benefits of the tax shield of debt are equal to the expected cost of financial distress (see Figure 7.1).
There are two ways to compare the benefits and costs, which are summarised in Table 7.1.
We shall start with the static approach.
Optimal leverage 1: WACC framework
The WACC approach is based on finding the leverage that minimises the WACC, given by formula (7.1).
| (7.1) |
Here we need to estimate several parameters and their dependence on leverage, namely:
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pre-tax cost of debt, C(Debt); and
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cost of equity, C(Equity).
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The other parameters are:
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market value22 In practice, for investment-grade companies the book value of debt can be taken as a good approximation for the market value of debt. of net debt, D;
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