6.5 Capital Structure, WACC, and Modigliani-Miller

Financing the asset base

Capital structure is the way a firm finances its assets with debt, equity, and sometimes hybrid securities. Debt has promised payments and priority over equity. Equity has residual claims and greater upside. The financing mix affects risk, expected return, governance, taxes, and flexibility.

Debt can be attractive because interest is often tax deductible. Debt can also discipline managers by forcing cash payments. But debt raises fixed obligations. Too much debt increases the probability of distress, reduces flexibility, and can force underinvestment when good projects appear during weak conditions.

Equity has no required interest payment and can absorb losses, but it is usually more expensive than debt because shareholders bear residual risk. Issuing new equity can also dilute existing owners and may signal that managers believe shares are overvalued.

WACC basics

Weighted average cost of capital is the required return on the firm's overall capital, weighted by each source of financing. For a firm using only debt and equity:

WACC = wD x rD x (1 - tax rate) + wE x rE.

Use market value weights when available because WACC reflects the current opportunity cost of capital. Book values can be stale. Target weights are often used when the firm manages toward a long-run capital structure.

The after-tax cost of debt is used because interest tax shields reduce the effective cost to the firm. The cost of equity is not tax adjusted because dividends and retained earnings do not create the same corporate interest tax deduction.

Leverage and risk

Increasing debt changes the distribution of cash flows. Creditors receive fixed claims first. Equity holders receive what remains. As debt increases, equity becomes riskier because residual cash flows are more volatile. Investors then require a higher cost of equity.

At moderate leverage, the tax shield may lower WACC. At high leverage, expected distress costs and agency costs can raise WACC. The practical optimum is where the marginal benefit of debt roughly balances the marginal cost.

Modigliani-Miller intuition

Modigliani and Miller developed benchmark propositions. In a perfect market with no taxes, no transaction costs, no bankruptcy costs, symmetric information, and fixed investment policy, capital structure does not affect total firm value. Investors can create homemade leverage on their own, so changing the firm's mix of debt and equity does not create value.

With corporate taxes and tax-deductible interest, debt can add value through the interest tax shield. In the simple tax model, more debt increases firm value. Real firms stop short of all-debt financing because distress costs, agency problems, loss of flexibility, and market frictions matter.

Target capital structure

A target capital structure is the debt-equity mix management seeks over time. It is usually a range, not a single fixed number. The target should match business risk, asset tangibility, cash-flow stability, tax position, growth opportunities, and the need for financial flexibility.

Stable utilities can often support more debt because cash flows are predictable and assets are tangible. Early-stage growth firms often use more equity because cash flows are uncertain and future investment needs are high. Cyclical firms may maintain lower leverage to survive downturns.

Structured aid: WACC interpretation

1. Estimate capital weights using market values or target market weights.
2. Estimate the before-tax cost of debt from current borrowing rates or yields.
3. Apply the tax adjustment to debt when interest is tax deductible.
4. Estimate the cost of equity using a suitable model or required return evidence.
5. Use project-specific rates when project risk differs from average firm risk.
6. Compare ROIC, project IRR, and NPV results with the appropriate cost of capital.

Exam focus

For calculations, apply the tax shield only to debt. If debt is 40 percent, equity is 60 percent, before-tax debt cost is 5 percent, tax rate is 25 percent, and equity cost is 10 percent, WACC is 0.40 x 5 percent x 0.75 plus 0.60 x 10 percent, or 7.5 percent.

For theory questions, keep the assumptions straight. MM no taxes gives irrelevance under perfect markets. MM with taxes gives debt tax-shield value. The real-world target structure reflects tax benefits, distress costs, agency conflicts, flexibility, and signaling.