Determining The Optimal CapitalStructure With The Contingent Claims Analysis

Finding the optimal capital structure has been a relevant subject for many decades. Therehas for a long time been a discrepancy between observed leverage ratio and those proposedby theory, with many different theories suggested and developed throughout time. One ofthose theories is the Contingent Claims Analysis (CCA). Based initially on Black & Scholes’option-pricing theory and formulas, and pioneered by Merton, the CCA-methodology hasthroughout the years been developed further and moved from pricing liabilities todetermining capital structures. The research and development on CCA-models have for thepast years mostly been on a theoretical level and less about its practical applicability. Thosefew applications that have been made were based on the U.S. market and companies.Ju and Ou-Yang developed one of the most recent CCA-methodologies in 2006,abbreviated as the JOY-model in this study. What distinguishes this model is its ability toshow the non-monotone relation of debt maturity and debt face amount through the morecomplex tradeoffs between tax benefits, bankruptcy costs and transactions cost. With a fewchanges made to it, and with almost all data from the Swedish market and companies, theJOY-model yields higher leverage ratios than what the 5 analyzed companies have today.The optimal leverage ratio, defined as debt value/firm value ranges from 10 – 40% and theoptimal debt maturity period is at 4 – 6 years. Out of all the model parameters, the long-runmean of the stochastic risk-free interest rate has the biggest impact on the final results. TheJOY-model and CCA in general are complex and resource intense models that need certainimprovements. Nonetheless, its overall potential is still promising