A New Model of Capital Structure Based on Portfolio Theory

In this paper, a theoretical model is introduced to solve for the optimal weights of debt (bonds) and equity (stocks) that determine the minimum weighted average cost of capital (WACC), which in turn leads to maximizing the value of the firm. The model uses a Lagrangian function to determine the optimal weights that minimize risk for a given level of return. The model’s unique contribution is its direct application of the efficient portfolio framework, typically used for investment management, to a firm’s capital components by treating debt and equity as a two-security portfolio. Empirical results of the model using real-world data show the robustness of the model in obtaining the optimal WACC.