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Corporate IssuersModule 6 of 7

Capital Structure

6

Concepts

4

Formulas

1

Decisions

4

Quiz Questions

Key Concepts

6 concepts covered in this module.

WACC

Weighted average cost of capital = wdrd(1-t) + were. Blended cost of debt and equity financing.

MM Proposition I (no taxes)

Capital structure is irrelevant to firm value in perfect markets. VL = VU.

MM Proposition II (no taxes)

Cost of equity increases linearly with leverage: re = r0 + (r0 - rd) × D/E.

MM with Taxes

Debt creates a tax shield: VL = VU + t×D. More debt increases firm value through interest tax deductibility.

Optimal Capital Structure

Balances tax benefits of debt against costs of financial distress. Minimizes WACC, maximizes firm value.

Pecking Order Theory

Firms prefer: 1) Internal financing, 2) Debt, 3) Equity. Due to information asymmetry — issuing equity signals overvaluation.

Formulas

4 essential formulas for this module.

WACC

WACC = wd × rd × (1-t) + we × re

Where: w = weight, rd = cost of debt, re = cost of equity, t = tax rate

MM Prop I (with taxes)

VL = VU + t × D

Where: Tax shield increases levered firm value

MM Prop II (no taxes)

re = r0 + (r0 - rd) × D/E

Where: r0 = unlevered cost of equity

Cost of Equity (CAPM)

re = rf + β × (rm - rf)

Where: rf = risk-free rate, β = beta, rm - rf = market risk premium

Decision Frameworks

1 decision frameworks to guide your analysis.

More debt or more equity?

  • More debt: stable cash flows, high tax rate, low financial distress costs (e.g., utilities)
  • More equity: volatile cash flows, high growth, significant intangible assets (e.g., tech)

Mind Map

Visual overview of how concepts connect in this module.

Capital Structure
WACC
w_d×r_d×(1-t) + w_e×r_e
Use market weights
Minimize WACC = maximize value
MM Propositions
No taxes: structure irrelevant
With taxes: debt adds value (tax shield)
Cost of equity rises with leverage
Optimal Structure
Tax shield benefit
Financial distress cost
Trade-off at optimal D/E
Pecking Order
Internal funds first
Then debt
Equity last resort
Information asymmetry

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