Optimal Leverage

Stanley Myint and Fabrice Famery

Contents

Foreword

Introduction

1.

Theory and Practice of Corporate Risk Management

2.

Theory and Practice of Optimal Capital Structure

3.

Introduction to Funding and Capital Structure

4.

How to Obtain a Credit Rating

5.

Refinancing Risk and Optimal Debt Maturity

6.

Optimal Cash Position

7.

Optimal Leverage

8.

Introduction to Interest Rate and Inflation Risks

9.

How to Develop an Interest Rate Risk Management Policy

10.

How to Improve Your Fixed-Floating Mix and Duration

11.

Interest Rates: The Most Efficient Hedging Product

12.

Do You Need Inflation-linked Debt?

13.

Prehedging Interest Rate Risk

14.

Pension Fund Asset and Liability Management

15.

Introduction to Currency Risk

16.

How to Develop Currency Risk Management Policy

17.

Translation or Transaction: Netting Currency Risks

18.

Early Warning Signals

19.

How to Hedge High Carry Currencies

20.

Currency Risk on Covenants

21.

Optimal Currency Composition of Debt 1: Protect Book Value

22.

Optimal Currency Composition of Debt 2: Protect Leverage

23.

Cyclicality of Currencies and Use of Options to Manage Credit Utilisation

24.

Managing the Depegging Risk

25.

Currency Risk in Luxury Goods

26.

Introduction to Credit Risk

27.

Counterparty Risk Methodology

28.

Counterparty Risk Protection

29.

Optimal Deposit Composition

30.

Prehedging Credit Risk

31.

xVA Optimisation

32.

Introduction to M&A-related Risks

33.

Risk Management for M&A

34.

Deal-contingent Hedging

35.

Introduction to Commodity Risk

36.

Managing Commodity-linked Revenues and Currency Risk

37.

Managing Commodity-linked Costs and Currency Risk

38.

Commodity Input and Resulting Currency Risk

39.

Offsetting Carbon Emissions

40.

Introduction to Equity Risk

41.

Hedging Dilution Risk

42.

Hedging Deferred Compensation

43.

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).

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).

  WACC = C(Debt)(1tax)DD+E+C(Equity)ED+E (7.1)

Here we need to estimate several parameters and their dependence on leverage, namely:

    • pre-tax cost of debt, C(Debt); and

    • cost of equity, C(Equity).

The other parameters are:

    • 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;

    • market value of equity, E, also known as “market capitalisation”; and

    • corpora

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