6.5 Capital Structure, WACC, and Modigliani-Miller

Financing the asset base

Capital structure is how a firm finances assets with debt, equity, and sometimes hybrids. Debt carries promised payments and priority over equity; equity holds the residual claim with greater upside. The mix shapes risk, expected return, governance, taxes, and flexibility.

Debt is attractive because interest is usually tax deductible, and required cash payments can discipline managers (reducing free-cash-flow agency cost). But debt adds fixed obligations: too much raises the probability of financial distress, cuts flexibility, and can force underinvestment, skipping good projects in weak periods. Equity has no required payment and absorbs losses, but it is usually more expensive because shareholders bear residual risk, and new issuance dilutes owners and may signal that managers think shares are overvalued.

WACC basics

WACC (weighted average cost of capital) is the firm's overall required return, weighted by each financing source. For debt and equity only:

WACC = w_D x r_D x (1 - t) + w_E x r_E

where w_D and w_E are weights, r_D and r_E are the costs of debt and equity, and t is the marginal tax rate. Use market-value weights (book values get stale) or target weights when the firm manages toward a long-run structure. The tax term (1 - t) multiplies only the cost of debt because interest creates a corporate tax deduction; dividends and retained earnings do not, so the cost of equity is never tax-adjusted, the single most common WACC error.

Leverage and risk

Adding debt reshapes the cash-flow distribution: creditors take fixed claims first, equity takes the remainder, so residual cash flows grow more volatile and the cost of equity rises with leverage. At moderate leverage, the tax shield can lower WACC. At high leverage, rising expected distress and agency costs push WACC back up. The practical optimum is where the marginal benefit of debt roughly offsets its marginal cost.

Modigliani-Miller propositions

Under MM Proposition I with no taxes (no transaction or bankruptcy costs, symmetric information, fixed investment policy), capital structure does not affect total firm value: investors replicate any leverage with homemade leverage, so the firm cannot create value by rearranging its mix. MM Proposition II adds that the cost of equity increases linearly with leverage, leaving WACC unchanged. Introduce corporate taxes and tax-deductible interest, and debt adds value via the interest tax shield, so in the simple tax model more debt raises firm value.

Real firms stop short of all-debt financing because distress costs, agency conflicts, lost flexibility, and signaling frictions matter, the logic of trade-off and pecking-order theory.

Target capital structure

A target capital structure is the debt-equity range management seeks over time, matched to business risk, asset tangibility, cash-flow stability, tax position, growth opportunities, and the need for flexibility. Stable utilities support more debt (predictable cash flows, tangible collateral). Early-stage growth firms lean on equity (uncertain cash flows, intangible assets, heavy reinvestment). Cyclical firms hold lower leverage to survive downturns.

WACC interpretation steps

1. Set capital weights from market values or target market weights.
2. Estimate the before-tax cost of debt from current yields.
3. Apply (1 - t) to debt only.
4. Estimate the cost of equity with a suitable model.
5. Use project-specific rates when project risk differs from firm risk.
6. Compare ROIC, IRR, and NPV against the appropriate cost of capital.

Costs of financial distress and agency costs of debt

The trade-off theory hinges on two cost categories the exam tests directly. Costs of financial distress split into direct costs (legal, administrative, and advisory fees in bankruptcy or restructuring) and indirect costs (lost customers and suppliers, forced asset sales at fire-sale prices, distracted management, and underinvestment). Indirect costs usually dwarf direct costs and are higher for firms with intangible or specialized assets, which lose value fast in distress. This is why software and pharmaceutical firms carry less debt than utilities with tangible, redeployable assets.

Agency costs of debt arise from the shareholder-creditor conflict. After borrowing, equity holders may pursue asset substitution (swapping safe projects for risky ones), underinvestment (skipping good projects whose gains accrue mostly to creditors), or large dividends that strip cash from the firm. Creditors anticipate this and price it into the cost of debt or restrict it through covenants, so the agency cost ultimately falls on shareholders.

Signaling and the pecking order

Because managers know more than outside investors (information asymmetry), financing choices carry signals. Issuing equity can signal that managers think shares are overvalued, often pushing the price down on announcement; issuing debt signals confidence in future cash flows. The pecking-order theory follows: managers prefer internal funds first, then debt, then equity as a last resort. A related idea is that maintaining financial flexibility, unused debt capacity and cash, lets a firm fund opportunities without issuing equity at a bad time.

Static trade-off, visually

Think of firm value as rising with leverage from the tax shield, then bending down as expected distress and agency costs accelerate. The optimal capital structure sits at the peak, where the marginal tax benefit of one more unit of debt equals the marginal increase in distress and agency costs. Beyond that point, additional debt lowers firm value and raises WACC.

Exam focus

Apply the tax shield only to debt. If debt is 40%, equity 60%, before-tax debt cost 5%, tax rate 25%, and equity cost 10%, then WACC = 0.40 x 5% x 0.75 + 0.60 x 10% = 1.5% + 6.0% = 7.5%. For theory, keep assumptions straight: MM no-taxes gives irrelevance; MM with taxes gives tax-shield value; the static trade-off balances tax benefits against direct/indirect distress and agency costs; pecking order ranks internal funds, then debt, then equity, driven by signaling.