M6: Capital Structure

What is a company's cost of capital?

The required rate of return investors demand for providing debt or equity financing to the company.

What is WACC?

Weighted-average cost of capital (WACC) is the weighted average required return on the company's sources of financing, principally debt and equity.

What is the WACC formula?

WACC = (D/V) × rd × (1 − t) + (E/V) × re, where D = market value of debt, E = market value of equity, V = D + E, rd = pre-tax cost of debt, re = cost of equity, and t = marginal corporate tax rate.

What do wd and we represent in the WACC formula?

wd = D/V is the weight of debt and we = E/V is the weight of equity. The weights sum to 1 when debt and equity are the only financing sources.

What is the after-tax cost of debt formula?

After-tax cost of debt = rd × (1 − t).

Why is the cost of debt adjusted for taxes in WACC?

Interest expense is generally tax-deductible, so debt creates a tax benefit that reduces its effective cost to the issuer.

Why is the cost of equity not multiplied by (1 − t)?

Dividends and share repurchases are generally not deductible from corporate taxable income, so equity does not receive the same tax adjustment as debt.

Why is debt generally less costly than equity?

Debt has a priority contractual claim on cash flows, may be secured by collateral, and receives a tax advantage from deductible interest. Equity is a residual claim and therefore requires a higher return.

★ On the Exam: What is the key tax adjustment in WACC?

Only the PRE-TAX cost of debt is multiplied by (1 − t). Do not apply the tax adjustment to the cost of equity.

⚠ Watch For: What if the question already gives the after-tax cost of debt?

Use the after-tax cost directly. Do NOT multiply by (1 − t) again.

What is the relationship between rd and re?

Debt is less risky than equity, so the required return on debt is generally lower than the required return on equity: rd < re.

Who determines the company's cost of debt and cost of equity?

Financial markets ultimately determine required returns. Management can influence them indirectly through risk, disclosure, governance, and capital allocation decisions but cannot simply choose rd or re.

How is the cost of debt estimated?

Use the yield investors currently require on new debt of similar risk. Comparable firms' recent borrowing yields can be useful for forward-looking analysis.

How is the cost of equity different from the cost of debt?

The cost of equity is not directly observable like a bond yield, so analysts must estimate the required return on equity.

What weights are generally preferred when calculating WACC?

Current market value weights are generally preferred because investors' opportunity costs reflect current market prices rather than historical book values.

How is market value of equity calculated?

Market value of equity = Current share price × Number of shares outstanding.

★ On the Exam: Market value vs book value weights for WACC?

Market value weights are generally preferred for WACC because they reflect current investor opportunity costs.

⚠ Watch For: If book equity and share price × shares outstanding are both provided, which should normally be used for WACC?

Use market equity = share price × shares outstanding when market-value weights are required.

How can WACC be used in capital budgeting?

WACC can serve as the NPV discount rate and IRR hurdle rate when the project's risk is consistent with the firm's overall risk.

⚠ Watch For: Should WACC always be used as the hurdle rate for every project?

No. The appropriate hurdle rate should reflect the risk of the specific project. Company WACC is appropriate only when project risk is consistent with overall company risk.

How does a rise in the pre-tax cost of debt affect WACC, all else equal?

WACC increases because the debt component becomes more expensive.

How does a rise in the cost of equity affect WACC, all else equal?

WACC increases because shareholders require a higher return.

How does a higher corporate tax rate affect WACC, holding pre-tax component costs constant?

A higher tax rate lowers the after-tax cost of debt and therefore lowers WACC because the debt tax shield becomes more valuable.

How does a lower corporate tax rate affect WACC, all else equal?

It raises the after-tax cost of debt and therefore raises WACC because the interest tax shield becomes less valuable.

What is the WACC sensitivity to a 1 percentage-point change in pre-tax cost of debt?

Change in WACC = wd × (1 − t) × 1 percentage point.

What is the WACC sensitivity to a 1 percentage-point change in cost of equity?

Change in WACC = we × 1 percentage point.

A firm has 30% debt, 70% equity, pre-tax rd = 6%, re = 12%, and t = 25%. What is WACC?

After-tax rd = 6% × 0.75 = 4.5%. WACC = 0.30 × 4.5% + 0.70 × 12% = 1.35% + 8.40% = 9.75%.

What are the two broad groups of factors affecting capital structure and WACC?

Internal factors specific to the issuer and external factors related to economic, market, and industry conditions.

What is a capital-intensive business?

A business requiring substantial investment in long-lived assets and working capital, typically characterized by low asset turnover and high capex relative to sales.

What financial characteristics commonly indicate a capital-intensive business?

Low asset turnover, high capital expenditures relative to sales, and relatively high net working capital requirements.

Why can mature capital-intensive businesses often support substantial debt?

Their tangible assets can serve as collateral and mature operations may generate sufficiently predictable cash flows to support fixed interest payments.

What is a capital-light business?

A business with relatively low requirements for physical assets and capital expenditure, often characterized by high asset turnover and greater reliance on intangible assets.

How does the corporate life cycle affect capital structure?

Startups generally rely heavily on equity, growth firms gain access to more debt while still using substantial equity, and mature firms with predictable cash flows can generally support more debt.

What is the typical capital structure of a startup?

Primarily equity from founders, employees, or venture capital. Debt availability is limited because cash flows are uncertain and failure risk is high.

What forms of debt may be available to startups?

Leases and sometimes convertible debt.

Why might startups use convertible debt?

Convertible debt provides financing today while giving investors the right to convert the debt into equity later.

What is the typical financing pattern of a growth company?

Equity remains important, but improving cash flow visibility may allow the company to access more debt, often secured debt.

What is the typical financing pattern of a mature company?

Mature companies generally have more predictable cash flows, greater access to unsecured debt, and may return capital through dividends or share repurchases.

Why do many mature firms target investment-grade credit ratings?

To preserve financial flexibility and maintain relatively low borrowing costs.

What is an issuer credit rating?

A general assessment of an issuer's capacity and willingness to meet its financial obligations, generally benchmarked against senior unsecured obligations.

What is an issue credit rating?

A rating assigned to a specific debt instrument that reflects its seniority, collateral, and structural features.

★ On the Exam: How can a secured issue rating compare with the issuer rating?

A secured bond may receive a HIGHER rating than the issuer rating because collateral provides additional creditor protection.

★ On the Exam: How can deeply subordinated debt be rated relative to the issuer?

Deeply subordinated debt may receive a LOWER issue rating because it has a weaker claim in the capital structure.

★ On the Exam: Issuer rating vs issue rating?

Issuer rating = benchmark of general creditworthiness. Issue rating = adjusted for the seniority, collateral, and structural features of the specific instrument.

What is a bond covenant?

A contractual provision designed to protect creditors by restricting or requiring specified issuer actions.

What is a negative covenant?

A covenant that PROHIBITS or restricts specified actions by the issuer.

What are examples of negative covenants?

Limits on additional borrowing, maximum leverage ratios, restrictions on dividends, asset sales, or mergers.

What is an affirmative covenant?

A covenant that REQUIRES the issuer to take specified actions.

What are examples of affirmative covenants?

Maintaining adequate insurance, providing audited financial statements, and preserving collateral.

★ On the Exam: Negative vs affirmative covenant?

Negative = issuer must NOT do something. Affirmative = issuer must DO something.

⚠ Watch For: Does "negative covenant" mean the covenant is bad for the issuer?

No. Negative refers to prohibiting an action, not whether the covenant is beneficial or harmful.

What can happen if a firm breaches a bond covenant?

A covenant breach may constitute an event of default and can give bondholders contractual remedies, potentially including accelerated repayment.

What top-down economic factors affect the costs of debt and equity?

Real economic growth, inflation, monetary policy, exchange rates, sovereign yields, and credit spreads can influence required returns.

How can recession risk affect a company's cost of capital?

Greater recession risk can increase credit spreads and required equity returns, especially for cyclical companies.

How do industry conditions affect cost of capital?

Industry exposure to economic variables affects cash flow risk and therefore investors' required returns on both debt and equity.

What four issuer-specific risk dimensions affect required returns?

Sales risk, profitability risk/operating leverage, financial leverage and interest coverage, and collateral/asset type.

What is sales risk?

The volatility and predictability of a company's revenues.

How does higher sales risk affect cost of capital?

Higher sales risk increases uncertainty around cash flows, generally increasing both the cost of debt and cost of equity.

What is operating leverage?

The degree to which a company's cost structure contains fixed rather than variable costs; the material expresses it as Fixed costs ÷ Total costs.

How does high operating leverage affect profit volatility?

With high fixed costs, a given percentage change in revenue causes a larger percentage change in operating profit.

How does high operating leverage affect cost of capital?

It increases operating risk, so both debt and equity investors generally demand higher required returns.

★ On the Exam: High fixed costs imply what?

High operating leverage → greater profit volatility for a given change in sales → greater risk → higher required returns.

What is financial leverage?

The use of debt financing, which creates fixed interest and principal obligations.

How does greater financial leverage affect financial risk?

More debt increases fixed financing obligations and makes equity cash flows riskier, increasing financial risk.

What is the interest coverage formula?

Interest coverage = Profit before interest and taxes ÷ Interest expense.

What does high interest coverage indicate?

A greater ability to service interest obligations, lower financial risk, and generally a lower cost of capital.

What does low interest coverage indicate?

Weaker ability to meet interest payments and greater financial risk.

How does strong collateral affect debt capacity?

Strong, tangible, readily marketable collateral generally increases debt capacity and can reduce the cost of debt.

What types of assets tend to provide strong collateral?

Tangible or fungible assets with ready resale markets, such as real estate, aircraft, automobiles, and high-quality receivables.

★ On the Exam: How do operating leverage and financial leverage differ?

Operating leverage comes from FIXED OPERATING COSTS. Financial leverage comes from DEBT and fixed financing obligations.

How can financial leverage affect ROE?

Debt can magnify ROE when business performance is strong, but it also magnifies downside risk and increases the volatility of shareholder returns.

⚠ Watch For: Can two companies with identical operating performance have different ROEs because of capital structure?

Yes. A more highly levered company can show a different ROE solely because it uses more debt and less equity.

What is the basic insight of Modigliani–Miller capital structure theory?

Under restrictive assumptions, capital structure by itself does not affect firm value. Relaxing assumptions such as taxes and financial distress changes the conclusion.

What key assumptions underlie the original MM framework?

Frictionless markets with no taxes, transaction costs, or distress costs; homogeneous expectations; equal borrowing/lending access; no agency costs; and separation of investment and financing decisions.

What does homogeneous expectations mean in MM?

Market participants have access to the same information and form the same expectations about future cash flows.

Why is equal borrowing and lending access important in MM?

It allows investors to replicate corporate leverage themselves through homemade leverage.

What is MM Proposition I without taxes?

VL = VU. The market value of a levered firm equals the market value of an otherwise identical unlevered firm.

★ On the Exam: What is the key conclusion of MM Proposition I without taxes?

Capital structure is IRRELEVANT. Changing the debt-equity mix does not change firm value.

Under MM without taxes, what determines firm value?

The expected future operating cash flows and their risk, not the split between debt and equity.

Under MM without taxes, what happens to WACC as leverage rises?

WACC remains CONSTANT at the unlevered cost of capital r0.

What is homemade leverage?

An investor personally borrows or lends to replicate the financial leverage of a company.

Why does homemade leverage support MM Proposition I?

If investors can replicate corporate leverage themselves at the same borrowing rate, they will not pay a premium merely because a company uses a different debt-equity mix.

★ On the Exam: What role does homemade leverage play in MM?

It is the arbitrage mechanism that forces VL = VU in the MM no-tax world.

What is MM Proposition II without taxes?

re = r0 + (r0 − rd) × (D/E).

What is r0 in MM Proposition II?

The required return on an all-equity/unlevered firm; under the no-tax MM model it is also the firm's constant WACC.

What happens to re as D/E rises under MM Proposition II?

re rises because leverage increases the financial risk borne by shareholders.

★ On the Exam: MM Proposition I vs Proposition II?

Prop I focuses on FIRM VALUE/capital structure. Prop II explains how the COST OF EQUITY changes as leverage changes.

Why does WACC remain constant under MM without taxes even though more cheap debt is used?

The benefit of increasing the weight of lower-cost debt is exactly offset by the rise in the required return on increasingly risky equity.

★ On the Exam: What happens to re when leverage rises under MM Proposition II?

re ALWAYS rises as D/E rises because shareholders bear greater financial risk.

Does MM without taxes assume bankruptcy cannot occur?

No. The model assumes financial distress or bankruptcy has no cost, not necessarily that default is impossible.

What changes when corporate taxes are introduced into MM?

Interest tax deductibility creates a debt tax shield, so debt financing can increase firm value.

What is MM Proposition I with corporate taxes?

VL = VU + tD.

What does tD represent in MM Proposition I with taxes?

The present value of the debt tax shield under the model's assumptions.

What is the debt tax shield?

The value created because interest expense reduces taxable income and therefore reduces corporate taxes.

★ On the Exam: Debt tax shield formula under MM with perpetual debt?

PV(debt tax shield) = tD.

If VU = 100, D = 40, and t = 25%, what is VL under MM with taxes?

Tax shield = 0.25 × 40 = 10. VL = 100 + 10 = 110.

What does MM with taxes and no distress costs predict about optimal leverage?

It predicts that firm value continually increases with debt, implying the unrealistic conclusion that 100% debt financing is optimal.

★ On the Exam: MM with taxes but no distress costs predicts what capital structure?

100% debt is optimal because every additional unit of debt adds tax-shield value with no offsetting distress cost.

What is MM Proposition II with taxes?

re = r0 + (r0 − rd) × (1 − t) × (D/E).

What is the structural difference between MM Proposition II with and without taxes?

The with-tax formula includes the factor (1 − t).