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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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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