CI 6 Capital Structure
Capital structure is the long-term financing on the right-hand side of the balance sheet: the mix of long-term debt and equity a firm uses to fund its assets. An issuer accepts a capital investment when its expected return clears a required rate of return, and that required rate is the issuer’s cost of capital. Because a firm draws on debt as well as equity, its cost of capital blends a cost of debt with a cost of equity.
Debt is less risky for the investor than equity. It carries a priority, contractual claim on the firm’s cash flows, it is sometimes secured by an asset that passes to the lender on default, and it has a fixed schedule, while equity is a residual claim of open-ended length. Lower risk means a lower required return, so an issuer’s cost of debt is always below its cost of equity.
The weighted-average cost of capital, or WACC, blends these two into a single number. After adjusting for any project-specific risk, WACC is the discount rate an issuer uses in net present value work and the hurdle rate for internal rate of return work.
Estimating each piece
The cost of debt is what lenders require on new borrowing. A sensible starting point is the rate on the firm’s outstanding unsecured borrowings, though a forward-looking estimate leans instead on what comparable companies have recently paid to borrow anew. Where interest is tax deductible, the nominal rate is cut to an after-tax figure.
The weights are either market value proportions or management target weights, the latter usually quoted in book value terms. Analysts reach for market value weights more often, since book values capture historical prices whereas an investor’s opportunity cost tracks today’s market prices.
The cost of equity has no observable interest rate to anchor it. It exceeds the cost of debt both because equity bears more risk and because distributions to shareholders are not tax deductible. One simple starting point is the long-run return on stocks in general: one broad market index compounded at 10 percent a year from 1928 to 2021, so these lessons use 10 percent as a first estimate for the cost of equity, then adjust for company-specific factors. If an issuer also uses financing with other risk and return features, such as preferred stock or non-controlling interests, its after-tax cost is added as a further weighted term.
ABC Corporation is financed with 40 percent debt and 60 percent equity and plans to keep those proportions as it raises new funds. Interest is tax deductible in its jurisdiction. Its lenders require 4 percent before tax, its shareholders require 10 percent, and the marginal tax rate is 23 percent.
Company X reports bonds of 400,000 dollars and common stock of 600,000 dollars (40,000 shares), for total liabilities and equity of 1,000,000 dollars. Its shares trade at 20 dollars. Lenders require 5 percent before tax and shareholders require 10 percent.
Issuers want a capital structure that minimizes WACC and roughly matches the duration of their assets. Two questions organize the choice: how much financing is needed and of what type, and what the component costs of debt and equity turn out to be. The first is driven mainly by the business model and the corporate life cycle; the second is set in financial markets by top-down forces and by issuer-specific risk.
How much financing, and what type
Some businesses are capital intensive: utilities, transportation, real estate, parts of manufacturing (semiconductors are one example), and natural resource extraction. They show low asset turnover, high capital expenditure relative to sales, and high net working capital relative to sales. Many once-integrated firms have since split the capital-heavy activity away from the customer-facing brand, holding the two together by contract rather than ownership. Hilton runs most of its rooms through franchise or management agreements on hotels owned by others, and NVIDIA designs chips that Taiwan Semiconductor Manufacturing Company and Samsung actually fabricate. A leased asset works much like a loan: the lessee receives the use of an asset in exchange for lease payments, at an implicit rate often below an unsecured borrowing rate because the asset is collateral. Secured debt works on the same logic. Government rules can also shape structure, as when banks must hold minimum equity against assets or regulated utilities face rate rules that push them toward more equity and a higher WACC.
Capital-light businesses, common in technology and in service firms that have shed their heavy assets, need few assets and show high fixed-asset turnover. Uber and Airbnb run networks whose cars and homes are owned by drivers and hosts, so they need no financing for those assets. Such firms may also charge customers upfront, run a short or negative cash conversion cycle, and pay staff largely in stock, all of which reduce the need to raise external cash.
The type of financing shifts across the corporate life cycle. Most firms do not hold a static structure; as business risk falls and free cash flow turns positive and steady, they can borrow more, on better terms, at lower cost.
| Feature | Startup | Growth | Mature |
|---|---|---|---|
| Revenue growth | Initial | Rising | Slowing |
| Free cash flow | Negative | Rising | Stable |
| Business risk | High | Medium | Low |
| Debt availability | Little or none | Rising | High |
| Debt type | Convertible | Secured | Unsecured |
At the startup stage, revenues are minimal and failure risk is high, so most financing is equity from founders, employees, and venture capital rather than an initial public offering, with the only debt available being leases and convertible debt. Growth firms still tend to run negative free cash flow, but improving visibility makes them more attractive to lenders, though equity stays predominant and debt is used conservatively. Mature firms generate reliable free cash flow and often carry significant debt, while frequently protecting an investment-grade rating to keep the cost of debt low and financial flexibility high.
What sets the costs of debt and equity
The two costs share their risk drivers and tend to move together, since each is a claim on one underlying cash flow stream. Top-down factors come first. Debt investors can hold nearly risk-free sovereign debt and demand a spread above it for issuer risk; macroeconomic conditions such as real growth, inflation, monetary policy, and exchange rates move both the base rate and credit spreads. As recession risk climbs, spreads widen, and the effect is sharper for cyclical sectors such as mining, materials, and industrials. Industry matters too: a rise in oil prices can tighten spreads for oil producers while widening them for airlines, for which fuel is a major cost.
Issuer-specific factors then adjust the required return around those base rates. Investors reward stable, predictable, growing revenues, which is why telecommunications and software firms on recurring subscription revenue borrow cheaply, while automobile and construction-equipment makers with cyclical sales pay more. Beyond revenue stability, the stability of margins matters, and that turns on the mix of fixed and variable costs, captured by operating leverage.
Financial leverage and interest coverage matter as well: a firm already carrying heavy debt is less able to support more, and high priority claims sit ahead of equity. Interest coverage measures whether core profit can service interest.
Finally, the assets themselves count. Strong collateral that throws off cash or is fungible and liquid, for instance aircraft, real estate, automobiles, and amounts owed by creditworthy customers, supports greater and cheaper borrowing.
Two all-equity firms each earn revenue of 100 and spend 70, for a base profit of 30 on equity of 100. Firm FC+ has fixed costs of 50 and variable costs of 20 percent of sales. Firm FC− has fixed costs of 20 and variable costs of 50 percent of sales. Test how each firm’s return on equity responds when sales move up or down by 25 percent.
| 25% decline | Base case | 25% rise | |
|---|---|---|---|
| Revenue | 75 | 100 | 125 |
| Fixed costs | 50 | 50 | 50 |
| Variable cost (20%) | 15 | 20 | 25 |
| Profit | 10 | 30 | 50 |
| Return on equity | 10% | 30% | 50% |
| 25% decline | Base case | 25% rise | |
|---|---|---|---|
| Revenue | 75 | 100 | 125 |
| Fixed costs | 20 | 20 | 20 |
| Variable cost (50%) | 37.5 | 50 | 62.5 |
| Profit | 17.5 | 30 | 42.5 |
| Return on equity | 18% | 30% | 43% |
Two firms each hold assets of 100, earn revenue of 100, and incur non-interest expenses of 70, for operating income of 30. Firm A carries 80 equity and 20 debt with interest of 2; Firm B carries 40 equity and 60 debt with interest of 9. Ignore income taxes. Test each firm as operating income moves up or down by 25 percent.
| 25% decline | Base case | 25% rise | |
|---|---|---|---|
| Operating income | 22.5 | 30 | 37.5 |
| Interest expense | 2 | 2 | 2 |
| Interest coverage | 11 | 15 | 19 |
| Profit | 20.5 | 28 | 35.5 |
| Return on equity | 26% | 35% | 44% |
| 25% decline | Base case | 25% rise | |
|---|---|---|---|
| Operating income | 22.5 | 30 | 37.5 |
| Interest expense | 9 | 9 | 9 |
| Interest coverage | 2.5 | 3.3 | 4.2 |
| Profit | 13.5 | 21 | 28.5 |
| Return on equity | 34% | 53% | 71% |
In a 1958 paper, Franco Modigliani and Merton Miller showed that, given a strict set of assumptions, a company’s financing mix does not change its value, where value is the present value of its expected future cash flows discounted at WACC. Managers cannot manufacture value by rearranging financing alone. The framework starts from these assumptions.
| Assumption | Meaning |
|---|---|
| Homogeneous expectations | Investors agree on an investment’s expected cash flows. |
| Perfect capital markets | No transaction costs, no taxes, and no bankruptcy costs, with information shared by all. |
| Risk-free rate | Investors may lend and borrow at the risk-free rate. |
| No agency costs | Managers always act to maximize shareholder wealth. |
| Independent decisions | Financing and investment decisions are separate. |
Modigliani and Miller later relaxed these assumptions to show that taxes and financial distress do give capital structure an effect on value, though a modest one next to future cash flows. The framework remains a useful starting point for thinking about the use of debt.
Proposition I without taxes: capital structure is irrelevant
The argument rests on homemade leverage. An investor can build whatever capital structure she prefers by borrowing and lending on her own account alongside owning the shares. If a firm is 50 percent debt and 50 percent equity but an investor wants the exposure of 70 percent debt, she can borrow to fund part of her share purchase, which is simply buying on margin and leaves the firm’s operating cash flows and value untouched. Arbitrage seals the result: if a levered firm and an otherwise identical unlevered firm had different values, investors could sell the overvalued one and buy the undervalued one for a riskless profit at no cost, forcing the two values together.
First, the value of the levered company equals the value of the unlevered company, that is VL = VU. Second, value is determined solely by expected future cash flows, not by the mix of debt and equity. Third, with no taxes, WACC is unaffected by capital structure.
Proposition II without taxes: leverage raises the cost of equity
Because debt is cheaper than equity, one might expect more debt to pull WACC down. It does not, because leverage raises the probability of bankruptcy and equity investors demand a higher return to bear that risk. Proposition II states that the lower cost of the added debt is exactly offset by the higher cost of equity, leaving WACC unchanged. The cost of equity climbs as a straight-line function of the debt-to-equity ratio.
Gerhardt Corporation is all-equity, with perpetual expected cash flows of EUR 5,000 and a cost of equity of 10 percent, which is also its WACC. Its value is therefore 5,000 / 0.10 = EUR 50,000. Gerhardt now issues EUR 15,000 of debt at 5 percent and uses the proceeds to buy back an equal amount of equity, leaving invested capital at EUR 50,000 (EUR 15,000 debt and EUR 35,000 equity).
Proposition I with taxes: the debt tax shield
In most jurisdictions interest is tax deductible, so debt shields profit from tax and the tax saved adds to firm value. Relaxing the no-tax assumption, Proposition I with corporate taxes states that the levered firm is worth more than the all-equity firm by the tax rate times the value of the debt, an amount equal to the present value of the interest tax shield.
Taken to its unrealistic extreme, Equation 5 implies a value-maximizing structure of 100 percent debt, since value rises without limit as debt is added.
Proposition II with taxes: WACC falls with debt
If value rises with debt, then WACC must fall with debt. The tax deduction lowers the cost of debt further, so the cheaper debt now more than offsets the rising cost of equity. The cost of equity keeps the same form but with a factor of (1 − t).
Return to Gerhardt, with perpetual pre-tax cash flows to shareholders of EUR 5,000 and a cost of equity and WACC of 10 percent, but now assume a corporate tax rate of 25 percent. As before, Gerhardt issues EUR 15,000 of 5 percent debt to repurchase equity.
The cost of financial distress
Financial distress is a sharp rise in doubt over whether a firm can honor its obligations, brought on by falling earnings power or outright losses. Leverage magnifies profit but also magnifies losses and the chance of distress, and a firm can start to lose customers, creditors, suppliers, and staff well before any bankruptcy filing. Direct costs are the cash expenses of bankruptcy, such as legal and administrative fees. Indirect costs include forgone business and investment, reputational damage, and the agency costs of debt that arise from conflicts between managers and debtholders near bankruptcy. Distress costs run lower when a firm’s assets can be resold easily in a secondary market, as with airlines and shipping companies, and higher for technology, pharmaceutical, and service firms that lack such saleable assets. The likelihood of distress climbs with heavier debt, greater sales risk, higher operating leverage, and thinner liquidity.
Rite Aid, a US pharmacy chain of over 2,000 stores, carried net debt above 5.0 times EBITDA for years. When pandemic testing and vaccine revenue faded and pricing and wage pressures grew, its high leverage amplified the profit downgrade. Over the first five months of 2022, its 02/15/2027 unsecured notes fell from 94 to 60 and its stock fell from 15 dollars to 6 dollars, and by May 2022 its cost of debt exceeded 20 percent. One analyst cut fair value from 16 dollars to 1 dollar and warned the shares might be worthless, citing 200 million dollars a year in interest, 225 million dollars in maintenance capital expenditure, and only 370 million dollars of expected EBITDA. Management moved to close 145 underperforming stores.
In a more realistic setting with both taxes and financial distress, the value-adding tax shield is offset by the value-reducing present value of expected distress and bankruptcy costs. Building the expected distress cost into the levered value gives the static trade-off theory.
Managers cannot pin down D* precisely, so they set a target capital structure using these trade-offs and the internal and external factors from earlier lessons. Actual structure can drift from the target: management may exploit a chance to issue debt at attractive rates, market values of debt and equity move on their own, and transaction costs and minimum deal sizes make constant fine-tuning impractical. For those reasons managers usually aim at a range, such as 30 to 50 percent debt, rather than a single point like 40 percent.
Target structures are often expressed in book values rather than market values. Market values swing and seldom change borrowing capacity, whereas a firm whose share price has jumped may raise equity to hold a target ratio. Management cares about the capital invested by the company, not the price a shareholder happened to pay in the market. And lenders, debt investors, and rating agencies mostly work in book values, so managers align policy to the measures those third parties use.
Target weights and WACC
WACC weights can come from current market values or from a target structure when management discloses one. An outside analyst who does not know the target can assume the current market-value structure is the target, infer it from capital structure trends and management statements, or use the average structure of comparable firms. A debt-to-equity ratio converts to a debt weight by dividing it by one plus itself.
Boulder, Inc., is a US-based unlevered firm with constant perpetual pre-tax cash flow of 6 million dollars a year, a market value of 45 million dollars, and a tax rate of 30 percent. It plans to issue 15 million dollars of debt at 5.5 percent to retire an equal amount of equity. The analyst estimates the present value of distress costs at several debt levels.
| Debt (D) | PV of distress | VL = VU + tD − distress |
|---|---|---|
| 5 | 0.1 | 46.4 |
| 10 | 0.2 | 47.8 |
| 15 | 0.5 | 49.0 |
| 20 | 1.5 | 49.5 |
| 25 | 6.0 | 46.5 |
| 30 | 12.0 | 42.0 |
Plover, Inc., is a European unlevered firm with constant perpetual pre-tax cash flow of EUR 10.0 million a year, a market value of EUR 100.0 million, and a tax rate of 20 percent. It issues EUR 35.0 million of debt at 4.5 percent to retire an equal amount of equity, keeping firm size unchanged. Assume distress costs are near zero.
Pecking order theory and agency costs
Managers know more about the firm than outside investors do, an asymmetry that raises the return investors demand, since they worry that new securities are being sold when they are overpriced or when creditworthiness is about to weaken. Because investors read management actions as signals, the pecking order theory, developed by Stewart Myers and Nicholas Majluf in 1984, ranks financing by how much information it reveals. Managers prefer internally generated funds first, then private debt, then public debt, and issue equity only as a last resort. A public equity issue tends to raise suspicion, since owners with strong prospects would be reluctant to share them, so equity issuance is often read as a negative signal, while issuing debt or committing to dividends signals confidence that future payments can be met. Under this view there is no optimal capital structure; a firm’s structure simply reflects its history of external financing needs.
Agency costs, the incremental costs of conflicts among managers, shareholders, and bondholders, also bear on the choice. Greater use of debt can reduce the agency costs of equity, because a more leveraged firm gives managers less room to overspend or waste cash. This underlies the free cash flow hypothesis that Michael Jensen advanced in 1986: heavier debt disciplines managers, compelling efficient operation so the firm can meet its interest and principal obligations.
CLP AG is a small listed biopharmaceutical company, consistently profitable and debt free, running a clinical trial of an already-approved drug for a new use. In July, management privately learns from the trial investigators that results look promising, and it arranges and publicizes a sizable expansion of its credit line, expecting to scale up production. In August, CLP announces successful results by press release and its shares rise 35 percent.