Capital Structure

Section: Capital Structure Estimated study time: 60 minutes Content: Capital structure theory addresses how firms choose the mix of debt and equity financing and whether this choice affects firm value. The Modigliani-Miller (MM) framework is the theoretical foundation at CFA Level 2. Under MM Proposition I with no taxes, firm value is independent of capital structure — the value of a levered firm equals that of an unlevered firm (V_L = V_U), because investors can replicate any capital structure through personal borrowing. Under MM Proposition II with no taxes, the cost of equity rises with leverage: r_e = r_0 + (D/E)*(r_0 - r_d), where r_0 is the cost of equity for an unlevered firm, r_d is the cost of debt, and D/E is the debt-to-equity ratio. The rising cost of equity exactly offsets the benefit of cheaper debt, leaving the WACC constant and firm value unchanged. When corporate taxes are introduced, interest payments are tax-deductible, creating a tax shield. Under MM with taxes, the value of the levered firm equals the value of the unlevered firm plus the present value of the tax shield: V_L = V_U + t*D, where t is the corporate tax rate and D is the amount of debt. This implies that firms should use 100% debt to maximize firm value — an unrealistic extreme. The trade-off theory reconciles this by arguing that the optimal capital structure balances the tax shield benefit of debt against the increasing costs of financial distress (direct costs such as legal and administrative fees, and indirect costs such as lost customers, constrained investment, and management distraction) as leverage rises. The optimal debt ratio occurs where the marginal benefit of the…