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CFA® Level I · Corporate Finance · free lesson

Capital Structure

How a company splits its financing between debt and equity affects its cost of capital, its risk, the returns its shareholders earn and the interests of everyone with a claim on it. This module shows how to calculate the weighted average cost of capital, explains what drives capital structure choices, including operating and financial leverage, works through the Modigliani-Miller propositions, and explains why companies settle on a target mix and how that choice can pit stakeholders against each other.

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What you will learn

1. Calculate and interpret a company's weighted average cost of capital using after-tax component costs and appropriate capital weights.

  • WACC = w_d x r_d x (1 - t) + w_p x r_p + w_e x r_e.
  • Use the after-tax cost of debt because interest is tax-deductible.
  • Use current market required returns, not historical coupons or book returns.
  • Weights: target capital structure first; otherwise current market values, not book values.
  • WACC rises with market interest rates and fits only projects of average company risk.

2. Explain the internal and external factors that influence a company's capital structure, including business risk, its life-cycle stage, and operating and financial leverage, and calculate the degrees of operating, financial and total leverage.

  • Stable cash flows and tangible assets support more debt; volatile revenue and intangible assets support less.
  • Life cycle: start-ups use equity, growth companies mostly equity, mature companies more debt.
  • DOL = contribution margin / EBIT; DFL = EBIT / (EBIT - interest); DTL = DOL x DFL.
  • External factors: interest rates and credit conditions, regulation, industry norms.
  • High operating leverage usually calls for lower financial leverage.

3. Explain the Modigliani-Miller propositions on capital structure without and with taxes, and calculate the resulting cost of equity, WACC and firm value.

  • MM assumes perfect markets: no taxes, no distress or transaction costs, symmetric information.
  • No taxes: V_L = V_U; r_e = r_0 + (r_0 - r_d) x D/E; WACC is constant at r_0.
  • With taxes: V_L = V_U + tD; r_e = r_0 + (r_0 - r_d)(1 - t) x D/E; WACC falls as leverage rises.
  • The cost of equity always rises with leverage because shareholders bear more financial risk.
  • Capital structure matters only because of imperfections such as taxes and costs of financial distress.

4. Describe the static trade-off theory, the costs of financial distress, pecking order and signaling considerations, and the use of a target capital structure.

  • Costs of financial distress: direct (legal and administrative) and indirect (lost customers, suppliers, staff and investment).
  • Static trade-off: V_L = V_U + tD - PV(costs of financial distress); optimum where marginal benefit equals marginal cost.
  • Pecking order: internal funds, then debt, then equity, because of asymmetric information.
  • Equity issues can signal overvaluation; debt can signal confidence.
  • Companies manage to a target range; actual weights drift with market values.

5. Describe how shareholders, creditors, managers and other stakeholders can have competing interests in capital structure decisions.

  • More debt can transfer value from existing creditors to shareholders, especially through debt-financed payouts.
  • In distress, shareholders may favor risky gambles and underinvest in safe projects; covenants protect creditors.
  • Managers may prefer too little debt (job security) or too much (EPS- or ROE-based pay).
  • Employees, suppliers and customers bear indirect distress costs and favor conservative financing.
  • Higher EPS after a recapitalization comes with higher risk; it does not prove value creation.

Module at a glance

This free module has 5 lessons, 16 practice questions with full explanations.

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