Learning Module 6
Capital Structure
What you must be able to do
Curriculum Year: 2026
Calculate and interpret the weighted-average cost of capital (WACC) for a company.
Explain factors affecting capital structure and the weighted-average cost of capital.
Explain the Modigliani–Miller propositions regarding capital structure.
Describe optimal and target capital structures, including pecking order theory.
1 · Weighted-Average Cost of Capital
A firm's WACC blends the costs of all financing sources into a single required rate of return used in NPV analysis and as the IRR hurdle rate.
WACC = (Wd × rd × (1 − t)) + (We × re)
Where:
Wd = Weight of debt (market value or target weight)
rd = Pre-tax cost of debt (yield on existing or new debt)
t = Marginal corporate tax rate
We = Weight of equity (1 − Wd if only debt and equity)
re = Cost of equity (equity investors' required return)
Interest is tax-deductible in most jurisdictions → multiply rd by (1 − t). Market value weights are preferred; target weights used when disclosed by management. Cost of equity is higher than cost of debt (equity is a residual, riskier claim).
WACC Worked Example
WACC = [0.04 × (1 − 0.23) × 0.40] + (0.10 × 0.60)
WACC = [0.04 × 0.77 × 0.40] + [0.10 × 0.60]
WACC = 0.01232 + 0.06 = 7.23%
Key Observations
Cost of debt (rd): Set by financial markets, not management. Use the yield on existing or newly issued debt. For forward-looking analysis, look at yields on comparable issuers' recent debt.
Cost of equity (re): Also market-determined; higher than cost of debt due to greater risk and non-deductible distributions. Historical long-run equity market return (~10% CAGR) is a common starting point.
Weights: Market value weights are preferred; book value weights reflect historical prices. A rising stock price → lower debt weight at market value vs. book value.
Rising tax rate → lower WACC: Higher tax rate increases the tax shield, reducing the after-tax cost of debt and thus WACC.
2 · Factors Affecting Capital Structure (LOS 6.b)
Business Model: Capital-Intensive vs. Capital-Light
Feature | Capital-Intensive | Capital-Light |
|---|---|---|
Asset turnover | Low | High |
CapEx / sales | High | Low |
Primary financing | Significant debt (secured/leases) | Equity or internal cash |
Examples | Utilities, semiconductors, transportation, real estate | Uber, Airbnb, software-as-a-service, Hilton (franchise model) |
Corporate Life Cycle and Debt Capacity
Life Stage | Revenue/FCF | Business Risk | Debt Access | Typical Debt Type |
|---|---|---|---|---|
Startup | Near-zero / Negative | Very high | Little or none | Leases; convertible notes |
Growth | Rising / Still negative | Medium | Improving | Secured debt |
Mature | Stable / Positive | Low | High | Unsecured (investment-grade bonds) |
Issuer-Specific Cost Drivers
Sales risk: Stable, recurring revenue (e.g., telecom subscriptions) → lower required returns. Cyclical revenues (autos, mining) → higher spreads.
Operating leverage: Fixed costs / Total costs. Higher operating leverage = greater profit variability for a given revenue change = higher cost of capital.
Financial leverage & interest coverage: Coverage = EBIT / Interest expense. Low coverage → high cost of debt and equity.
Asset quality (collateral): Tangible, fungible assets (real estate, aircraft, receivables) support lower-cost secured debt. Intangible-heavy firms face higher distress costs.
Operating leverage = Fixed costs / Total costs
Interest coverage = EBIT / Interest expense
= Profit before interest and taxes / Interest expense
Higher operating leverage amplifies profits when revenue rises but also deepens losses when revenue falls — increasing the probability of financial distress.
3 · Modigliani–Miller (MM) Propositions
MM's 1958 framework begins under restrictive assumptions (no taxes, no transaction costs, no bankruptcy costs, homogeneous expectations, risk-free borrowing for all) and is gradually relaxed to incorporate real-world frictions.
Capital structure is irrelevant.
Value of levered firm (VL) = Value of unlevered firm (VU)
Firm value determined solely by expected future cash flows
WACC unaffected by capital structure
Basis: "Homemade leverage" — investors can replicate any firm leverage at no cost
Higher leverage raises cost of equity — exactly offsetting lower-cost debt.
re = r0 + (r0 − rd) × D/E
Cost of equity rises linearly with D/E ratio
Increase in re exactly offsets cheaper debt → WACC unchanged
Higher leverage does NOT increase firm value
WITHOUT TAXES:
re = r₀ + (r₀ − rd) × (D/E)
WITH CORPORATE TAXES:
re = r₀ + (r₀ − rd) × (1 − t) × (D/E)
WHERE:
r₀ = Cost of capital for all-equity firm (unlevered WACC)
rd = Cost of debt
t = Corporate tax rate
D/E = Debt-to-equity ratio (market values)
With taxes: re still rises with leverage but at a slower rate due to the (1 − t) term. The tax benefit of debt outweighs the equity cost increase → WACC declines with leverage.
Debt creates value via the tax shield.
VL = VU + tD
t = tax rate; D = market value of debt
tD = present value of the debt tax shield
Extreme conclusion: 100% debt maximizes value (unrealistic)
WACC decreases as debt increases (tax shield benefit exceeds equity cost rise).
WACC falls as the firm uses more debt
Firm value increases with leverage
With taxes but no distress costs: 100% debt is optimal
In reality, financial distress costs offset the tax shield
MM Framework Summary
Proposition | WACC as leverage ↑ | Firm Value | Cost of Equity |
|---|---|---|---|
MM I without taxes | Unchanged | Unchanged (= VU) | Rises (offsets cheaper debt) |
MM II without taxes | Unchanged | Unchanged | Rises linearly with D/E |
MM I with taxes | Falls | Rises: VL = VU + tD | Rises (slower than no-tax case) |
MM II with taxes | Falls | Rises | Rises but at slower rate |
Cost of Financial Distress
Direct costs: Legal and administrative fees associated with bankruptcy proceedings.
Indirect costs: Lost customers, suppliers, employees; foregone investments; reputational damage; agency conflicts between managers and bondholders near insolvency.
Costs are lower for firms with tangible, fungible assets (airlines, shipping) and higher for technology, pharma, and service firms (mostly intangibles).
Example: Rite Aid — net debt/EBITDA > 5×; cost of debt exceeded 20% as financial distress deepened in 2022.
4 · Optimal & Target Capital Structure
VL = VU + tD − PV(Costs of financial distress)
Optimal debt level D* occurs where:
Marginal tax benefit of debt = Marginal cost of financial distress
At D*: firm value is maximized.
Beyond D*: financial distress costs outweigh the tax shield → value falls.
In practice, managers cannot precisely estimate D* and instead set a target capital structure range (e.g., 30%–50% debt) guided by credit rating objectives, book-value leverage ratios, and market conditions.
Why Target Capital Structure Uses Book Values
Market values fluctuate and seldom determine actual borrowing capacity.
Management focus: amount and types of capital invested, not market prices of securities.
Lenders and rating agencies focus on book-value leverage ratios (debt/EBITDA, debt/equity) → managers align to these measures.
Estimating Target Weights (Three Methods)
Method | Approach | When Best Used |
|---|---|---|
Current structure | Use current market value weights as a proxy | When no target is disclosed |
Trend / management guidance | Examine capital structure trends or management statements about leverage targets | When management communicates a target range |
Peer-group average | Average capital structures of comparable companies | For new issuers or when historical data is unreliable |
Tip: To convert D/E ratio to a debt weight: Wd = (D/E) / (1 + D/E)
Pecking Order Theory
Managers know more about the firm than investors. To avoid negative signals, managers prefer financing sources with the least information content:
1st preference → Internal funds (no floatation costs, no signal)
2nd preference → Private debt (less signal than public debt)
3rd preference → Public debt
Last resort → Equity issuance (most information content; signals overvaluation)
Result: No single optimal capital structure — a firm's leverage reflects its cumulative history of external financing needs.
Free Cash Flow Hypothesis (Jensen 1986)
Mandatory interest and principal payments reduce free cash flow available for wasteful spending or empire-building acquisitions. Higher leverage thus reduces agency costs of equity, benefiting shareholders in firms with low-growth, cash-generative businesses.