3.1 Capital Structure

Why Capital Structure Matters for FMVA

Capital structure is the mix of claims that finance a firm's operating assets: debt, common equity, and sometimes preferred stock. For the FMVA final, this is not a corporate-theory sidebar. The mix supplies the weights in the weighted average cost of capital (WACC), and WACC is the discount rate applied to unlevered free cash flow (UFCF) in a discounted cash flow (DCF) model. Wrong weights produce a wrong rate; a wrong rate misstates every present-value cell downstream, including terminal value.

CFI's core valuation courses treat WACC as a market-value weighted blend of investor required returns. Those returns are opportunity costs, not accounting entries. Debt holders, preferred holders, and common shareholders each require a return they could earn on a comparable-risk claim elsewhere. The firm's job in a DCF is to pay that blended required return on the capital that remains invested in the business.

Finance is about 10% of the FMVA final. Cost of capital sits in that domain and then reappears in Valuation (about 30%) whenever a case study asks you to discount cash flow. Elective LBO or deal-structure courses are not on the final; the core ideas in this chapter are.

Debt, Common Equity, and Preferred

Debt is a contractual claim. Lenders receive interest and principal on a schedule. Interest is generally tax-deductible for a taxable corporation, which is why CFI's after-tax cost of debt is Rd × (1 − T). Debt stands ahead of equity in bankruptcy, so Rd is usually the lowest pre-tax required return among the three claims. The relevant Rd is the yield to maturity (YTM) on existing debt of similar seniority and tenor — not the coupon printed on an old bond issued when rates were different.

Common equity is a residual claim. Common shareholders receive whatever cash remains after operations, taxes, interest, and preferred dividends. There is no contractual coupon, so the cost of equity (Re) is inferred from a model such as the capital asset pricing model (CAPM), which the next section builds in full. Equity is the most junior claim, so Re is typically the highest of the three component costs. Dividends on common are not tax-deductible; there is no (1 − T) factor on the equity slice of WACC.

Preferred stock sits between debt and common. Preferred usually pays a fixed dividend and has priority over common dividends, but those dividends are not tax-deductible. If preferred is material, CFI's extended WACC adds (P/V) × Rp with no tax shield. Treating preferred like debt and multiplying by (1 − T) understates WACC — a frequent exam trap.

Trade payables, accrued expenses, and deferred revenue are operating liabilities, not invested capital. They affect working capital and UFCF. They do not get a D/V weight in WACC. Putting accounts payable into the debt weight is an integrity error: you would be treating a supplier's invoice as if it were a bond.

Market Values, Not Book Values

The balance sheet reports book value: historical contributed capital plus retained earnings for equity, and amortized principal for debt. Investors cannot buy the firm at book. They transact at market value. WACC is a market required return, so:

• E = share price × diluted shares outstanding (equity market capitalization)
• D = market value of interest-bearing debt (traded price of bonds, or a disclosed fair-value proxy if the notes do not trade)
• V = E + D, or E + D + P if preferred is in the capital stack

Using book equity systematically understates E for a profitable firm that has retained earnings for years. That overstates the debt weight, overstates the tax shield, and understates WACC — which overstates DCF value. Using face value of debt when the bonds trade at a large premium or discount misstates D. CFI's modeling standard is explicit: E and D are market values.

Net debt versus gross debt is a bridge-to-equity decision, not a WACC-weight decision. If you will subtract net debt (interest-bearing debt minus non-core cash) when you go from enterprise value to equity value, be consistent: either use gross D in the WACC weights and subtract cash later, or use a net-debt weight and do not subtract the same cash again. Double-netting cash is a silent value error.

Current Structure versus Target Structure

A firm's current capital structure is today's snapshot: this close's market cap, this close's drawn revolver, this close's preferred. That snapshot can be noisy. The firm may have just issued a large bond, may be sitting on cash after an asset sale, or may have a temporarily depressed share price that inflates D/V. Plugging a transitory mix into a going-concern DCF implies the firm will keep that mix forever, including through the terminal-value year.

Target capital structure is the mix management intends to maintain over the forecast horizon: a target D/E, a credit-rating band, or a net-debt-to-EBITDA ceiling. In a CFI-style DCF, use target weights unless you have a specific reason to model a path of changing leverage (for example, a disclosed deleveraging plan with an explicit debt schedule). Practically, analysts often take the current market mix as the best observable proxy for the target when the firm is already near its stated policy, and they switch to peer-median or management-stated targets when the current mix is clearly transitory.

Worked Example: Harbor Tools Weights

Harbor Tools currently has:

• 40 million shares at $20.00 → E = $800 million
• Bonds with $250 million face trading at 96 → D = $240 million
• No preferred
• V = $1,040 million
• Current weights: E/V = 800/1,040 = 76.9%, D/V = 240/1,040 = 23.1%

Book equity is $420 million and book debt is the $250 million face. Book weights would be 62.7% equity / 37.3% debt — a completely different firm on paper. Those book weights are not WACC inputs.

Management's stated policy is 30% debt / 70% equity at market. Last quarter the firm drew a revolving credit facility to fund a one-time inventory build; it plans to repay the extra debt within 12 months. For a going-concern WACC used to discount five-to-ten years of UFCF plus a terminal value, the target 30/70 mix is the correct set of weights. Using 23.1% debt would understate the tax shield the firm intends to keep and would not match the leverage you will use when you relever beta in the next section.

If you instead model an explicit forecast in which debt pays down to a new steady state, you can keep a constant target WACC and let the debt schedule affect cash flow (interest, mandatory paydown) without changing the discount rate each year. Mixing a changing capital structure into both the cash flows and a year-by-year WACC without a consistent adjusted present value (APV) framework is an integrity error. Core FMVA DCF uses one WACC, one target mix.

Leverage, Distress, and the Two Kinds of Leverage

The bar chart is illustrative, not a published CFI table of official WACC percentages. It exists to lock the shape: WACC can fall as cheap after-tax debt replaces equity, then rise as distress reprices both Rd and Re. Do not memorize 7.8% as "the" optimal WACC.

Why More Debt Can Lower WACC — Then Raise It

Debt is cheaper than equity for two separate reasons: seniority (lenders bear less risk than residual owners, so Rd < Re) and the interest tax shield. Holding Re and Rd fixed, replacing equity with debt lowers WACC because you put more weight on the cheaper after-tax claim. That is the downward-sloping left side of the curve (0% → 40% debt in the illustration).

The curve does not keep falling. As leverage rises:

1. Rd increases. Lenders demand a higher YTM as default risk rises. Covenants tighten. The firm may lose investment-grade pricing or lose access to unsecured markets.
2. Re increases. Equity becomes a smaller, riskier residual. CAPM beta rises with D/E — the levered-beta formula in section 3.2 is the mechanical link.
3. Distress costs appear. Direct costs (legal fees, fire-sale asset discounts) and indirect costs (lost customers, delayed capex, employee flight) destroy operating cash flow. Those costs are not inside the WACC formula; they show up as lower UFCF. If you ignore them and keep pushing D/V up, the model overstates value even if you remember to lift Rd and Re.

The result is a U-shaped WACC. Moderate debt can reduce WACC; excessive debt raises component costs and can raise WACC even before you count distress drag on cash flow. FMVA does not ask you to compute an "optimal" D/E from a closed-form formula. It does ask you to explain the tradeoff and to refuse the trap that "more cheap debt always lowers WACC."

Return to Harbor Tools. Suppose Re is 10.0%, Rd is 5.0%, and T is 25% at the 30% debt target:

WACC = 0.70 × 10.0% + 0.30 × 5.0% × (1 − 0.25) = 7.00% + 1.125% = 8.125%

If the firm instead levers to 80% debt, it is no longer plausible to keep Rd at 5.0% and Re at 10.0%. A stressed Rd of 9.0% and a levered Re of 16.0% would give:

WACC = 0.20 × 16.0% + 0.80 × 9.0% × 0.75 = 3.20% + 5.40% = 8.60%

WACC rose, and that calculation still ignores lost UFCF from customers walking away. "Debt is cheaper, so more of it must help" is the trap.

Operating Leverage versus Financial Leverage

Operating leverage is the share of operating costs that are fixed (rent, salaried staff, depreciation of a plant) rather than variable (materials, piece-rate labor, shipping). High operating leverage means a small change in revenue produces a large change in earnings before interest and taxes (EBIT). A software firm with high gross margins and a large research staff has more operating leverage than a grocery retailer whose cost of goods moves almost one-for-one with sales.

Financial leverage is the use of fixed financing costs — interest and preferred dividends — on top of operating results. High financial leverage means a small change in EBIT produces a large change in earnings to common. The two stack. A firm with high operating leverage that then layers on high financial leverage has a very volatile residual for common equity, which shows up as a high equity beta.

In modeling, do not "fix" a high-beta cyclical manufacturer by stuffing the WACC with extra debt to cheapen the discount rate. The extra debt raises levered beta and Re, and the operating-leverage story already lives in the cash-flow forecast as wide swings in EBIT. Consistency between the operations you forecast and the capital structure you assume is part of the same audit mindset CFI teaches for three-statement models.

Practical Checks Before You Lock Weights

Before a WACC is used in a DCF or as a hurdle rate:

• Confirm E is market cap, not book equity, not par value, and not retained earnings plus paid-in capital.
• Confirm D is interest-bearing debt at market, excluding operating liabilities such as trade payables.
• Decide whether cash is netted consistently with the enterprise-value-to-equity bridge you will use later.
• Align the D/E used to relever beta with the D/E implied by the WACC weights. Target 30% D/V means D/E = 0.30/0.70 = 0.429, not the current 240/800 = 0.30.
• If preferred exists, include it as its own slice with no tax shield.
• Do not treat a one-quarter revolver spike as the firm's forever mix.

Those checks belong next to the color-convention and balance-check discipline you will use in three-statement models. Labels, units, and economic consistency are the same skill applied to a rate instead of a cash-flow statement.