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Capital Structure

Understand how the mix of debt and equity affects firm value, risk, and WACC. Explore Modigliani-Miller and trade-off theory. Capital structure theory answers one of the most fundamental questions in corporate finance: does how you finance a firm change what the firm is worth?

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Key Concepts

1
Modigliani-Miller Proposition I (no taxes)
2
Modigliani-Miller Proposition II (leverage and Re)
3
MM with corporate taxes and the tax shield
4
Trade-off theory (tax shield vs distress costs)
5
Pecking order theory
6
Financial distress and bankruptcy costs
7
Target capital structure
8
Agency costs of debt and equity

Study Tips

  • Start with the MM no-tax world, then add taxes
  • Trade-off theory balances tax shield vs distress costs
  • Pecking order says firms prefer internal funds first
  • Optimal D/E varies by industry

Common Mistakes to Avoid

Applying MM propositions without checking the assumptions. In a world with taxes, debt adds value through the tax shield. Students also forget that MM Prop II says cost of equity rises linearly with leverage, which is why more debt does not always lower WACC.

Capital Structure FAQs

Common questions about capital structure

Only up to a point. Beyond the optimal level, expected bankruptcy costs and financial distress outweigh the tax benefits of additional debt. The trade-off theory describes this balance.

Firms prefer internal financing first, then debt, then equity as a last resort. This order reflects information asymmetry costs: issuing equity signals to the market that management thinks the stock is overvalued.

When a firm has significant debt, shareholders may take excessive risks because they benefit from the upside while creditors bear the downside. This creates costs like restrictive covenants, monitoring, and suboptimal investment decisions that reduce firm value.

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