🏗️ Capital Structure
Definition: Capital structure refers to how a company finances its assets through a combination of equity, debt, and hybrid securities. The central question: Is there an optimal debt-equity mix?
Modigliani-Miller Theorem forms the theoretical foundation. Key courses: Wharton FNCE 621, HBS Finance II, Booth BUSF 33001
🔑 The Modigliani-Miller Theorems
MM Proposition I (No Taxes): Capital Structure is Irrelevant
“The value of a firm is independent of its capital structure.” — Franco Modigliani & Merton Miller, 1958
In a perfect market (no taxes, no bankruptcy costs, no asymmetric information), how you finance doesn’t change firm value. Investors can replicate any leverage structure themselves (“homemade leverage”).
MM Proposition II (No Taxes): Cost of Equity Rises with Leverage
As debt increases, equity holders face more risk (they’re the residual claimants), so they demand higher returns:
MM Proposition I (With Taxes): Debt Has a Tax Shield
Interest is tax-deductible → government subsidizes debt financing. The present value of tax shields adds to firm value:
→ Under MM with taxes, 100% debt is optimal (all equity financed by tax shields).
But we don’t observe 100% debt in the real world — why?
⚖️ The Trade-Off Theory
Optimal leverage balances:
| Force | Effect on Leverage |
|---|---|
| Tax shield | Encourages more debt |
| Financial distress costs | Limits debt |
| Agency costs | Debt can reduce free cash flow waste |
| Signaling | More debt signals management confidence |
Optimal D/E = where marginal tax benefit = marginal distress cost
🔄 Pecking Order Theory (Myers-Majluf)
Due to information asymmetry, companies prefer:
- Internal funds (retained earnings) — first
- Debt — second
- New equity — last (signals undervaluation to market → price drop)
This explains why issuing new stock is often bad news for share price.
📊 Leverage by Industry
| Industry | Typical D/E | Why |
|---|---|---|
| Utilities | 150–400% | Stable cash flows, asset-heavy |
| Airlines | 100–200% | Capital-intensive, cyclical |
| Tech companies | 0–30% | Intangible assets, volatile |
| Banks | 1000%+ | Leverage is the business model |
| Real Estate | 200–600% | Hard assets secure debt |
🎯 Practical Capital Structure Decisions
Factors CFOs Consider:
- Debt capacity: Can we service the debt in a downturn?
- Credit rating: Investment grade vs. sub-investment grade
- Flexibility: Keeping dry powder for acquisitions
- Shareholder base: What does our investor base prefer?
- Peer benchmarking: Industry norms matter
🔗 Connected Concepts
- WACC — capital structure directly determines WACC weights
- DCF Valuation — firm value depends on capital structure (through WACC)
- LBO Model — extreme leverage case study
- Dividend Policy — related financing decision
- M&A Process — capitalization changes in deals
🏫 School Context
- Wharton: MM derived rigorously; students debate trade-off vs. pecking order empirically
- Booth: Economics-first — markets determine capital structure optimality
- HBS: Case-based; cases like “Marriott Corporation Cost of Capital” explore real CFO decisions
← 📊 Finance MOC | Related: WACC · LBO Model · Dividend Policy