Chapter 5: Capital Structure | CFA Corporate Issuers

What is Capital Structure?

Capital Structure Definition

Capital structure refers to the specific mix of debt and equity a company uses to finance its assets and operations. The primary goal of managing capital structure is to find the perfect balance that maximizes the company's value by minimizing its overall cost of capital.

The Cost of Capital

The cost of capital is the minimum return a company must earn on its investments to satisfy its investors (both debtholders and shareholders). This is most commonly measured by the Weighted Average Cost of Capital (WACC).

Calculating the WACC

WACC = (Wd × Kd × (1 - t)) + (We × Ke)

Wd: Weight of debt in the capital structure

Kd: Cost of debt (the interest rate the company pays on its debt)

t: Corporate tax rate

We: Weight of equity in the capital structure

Ke: Cost of equity (the return shareholders require)

Illustrative Example: Calculating WACC

A company has a capital structure of 40% debt and 60% equity. The pre-tax cost of its debt is 5%, its cost of equity is 10%, and the corporate tax rate is 25%.

Step 1: Calculate the after-tax cost of debt.
After-Tax Cost of Debt = Kd × (1 - t) = 5% × (1 - 0.25) = 3.75%

Step 2: Calculate the WACC.
WACC = (0.40 × 3.75%) + (0.60 × 10%)
WACC = 1.5% + 6.0% = 7.5%

Conclusion: The company's WACC is 7.5%. This is the minimum average return it must earn on its assets to satisfy all its investors.

Management Goals for Capital Structure

Minimize WACC

Find the debt-equity mix that results in the lowest possible overall cost of capital.

Match Capital Sources to Investments

Align the time horizon of the funding (short-term debt vs. long-term equity) with the life of the assets being financed.

Factors Affecting Capital Structure

A company's choice of capital structure is influenced by a variety of internal and external factors.

Internal Factors

Business Model: Stable, recurring revenues can support more debt. High operating leverage increases risk, favoring less debt.
Asset Type: Companies with tangible assets (like real estate or machinery) can use them as collateral to obtain cheaper debt.
Profitability & Liquidity: Higher profits and strong cash flow indicate a greater ability to service debt.

External Factors

Market Conditions: Low interest rates make debt financing more attractive.
Regulatory Constraints: Some industries (e.g., banking) have regulations that dictate capital structure.
Industry Norms: Companies often have capital structures similar to their peers.
Credit Ratings: Higher ratings from agencies like S&P and Moody's lead to a lower cost of debt.

Capital Structure and the Company Lifecycle

Stage	Typical Capital Structure
Start-up	Relies heavily on equity (e.g., venture capital) due to high risk and negative cash flow.
Growth	Debt becomes more accessible as assets grow and cash flow improves, but equity is still dominant.
Mature	Debt becomes cheaper and forms a larger part of the structure due to positive, predictable cash flows.

Theories of Capital Structure

Several theories attempt to explain how companies should choose their capital structure.

Modigliani-Miller (M&M) Theory

The M&M theory provides the foundation for modern capital structure theory.

M&M Proposition I (No Taxes): In a perfect market (no taxes, no bankruptcy costs), a company's value is unaffected by its capital structure. Value is determined by cash flows, not the financing mix. (Value of Levered Firm, VL = Value of Unlevered Firm, VU).

M&M Proposition II (No Taxes): The cost of equity increases linearly as a company increases its use of debt. This is because financial risk for shareholders rises with leverage, and they demand higher returns to compensate.

M&M with Corporate Taxes: When corporate taxes are introduced, debt becomes valuable because interest payments are tax-deductible. This creates a "debt tax shield." The value of the levered firm is now higher than the unlevered firm. (VL = VU + tD).

Static Trade-off Theory

This theory builds on M&M by introducing the costs of financial distress (e.g., bankruptcy costs). It posits that the optimal capital structure is a trade-off between the tax benefits of debt and the costs of potential financial distress.

VL = VU + tD - PV(Costs of Financial Distress)

Initially, adding debt increases firm value due to the tax shield. However, after a certain point, the rising probability of financial distress outweighs the tax benefits, and the firm's value begins to decline. The peak of this curve represents the optimal capital structure.

Pecking Order Theory

This theory focuses on the signaling effects of financing choices. Due to information asymmetry (managers know more than investors), companies are said to prefer a specific "pecking order" of financing:

Internal Funds (Retained Earnings)

The most preferred source, as it sends no negative signals to the market.

Debt

Preferred over equity because it signals management's confidence in future cash flows.

External Equity (New Shares)

The least preferred source, as it is often interpreted by investors as a signal that the company's stock is overvalued.

Optimal vs. Target Capital Structure

While theories define an optimal structure, in practice, companies aim for a target structure.

Optimal Structure

The theoretical point of perfect balance that maximizes firm value. It is difficult to identify precisely.

Target Structure

The capital structure a company aims for over time. It may deviate from the optimal structure due to market fluctuations, financing opportunities, or transaction costs.

Key Insight

In practice, companies continuously adjust their capital structure in response to changing business conditions, market opportunities, and strategic objectives. The goal is to maintain flexibility while optimizing the cost of capital over time.