TechniqueFrameworkCreditDeals and M&AValuation
How much debt is the right amount: the cost-of-capital approach
Aswath Damodaran · Session 18: Optimum Capital Structure — The Cost of Capital Approach
The idea
Debt is cheaper than equity until the point where the risk it adds raises the cost of both. Damodaran's cost-of-capital approach asks, for each level of leverage, what the firm's rating would be, what that rating would cost in interest, how the beta would rise with the extra financial risk, and what the blended cost of capital comes out at. The optimum is where that blended cost is lowest, not where a lender stops saying yes. In a buyout the same question sits under the debt stack: the model's return depends on how much debt was used, and the right amount is a function of the business's cash flows, not of the sponsor's appetite.
The right amount of debt minimises the blended cost of capital; the maximum a lender will provide is a different and larger number.
When it works
LBO and leveraged finance questions on how much debt a deal can carry, and corporate finance questions on capital structure.
When it may fail
Synthetic ratings and the beta adjustment are approximations, and a buyout's leverage is also set by what the debt markets will bear that year. The approach gives the right question, not a market price.
How to use it
In the Capital Structure lab, step leverage up and watch the cost of capital fall and then rise. Mark the turn, then compare it with the leverage a typical buyout uses and say what the sponsor is accepting in exchange.
Where it came from
Video Session 18: Optimum Capital Structure — The Cost of Capital Approach · Aswath Damodaran (NYU Stern)
What the source says. Damodaran works the cost-of-capital approach to optimal capital structure: for each debt ratio, the implied rating, the cost of debt, the levered beta, and the resulting cost of capital.
Connected ideas
Worth knowing first
A capital-structure-neutral cash flow needs a capital-structure-neutral discount rateMatch the discount rate to the cash flow: a flow to all capital providers is discounted at the blended cost of all of them.
Says something similar
The duration and covenants of a loan matter as much as the amount of leverageAsk when the debt comes due, what it can reach, and what trips it, before asking how much there is.
Concepts
Put it to work on L3VLUP
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