Every company has to decide how to fund itself, with money from lenders or money from owners, and the mix shapes everything from its cost of capital to whether it survives a downturn. This deck explains the choice: why debt is cheaper than equity, why it stops being cheaper past a point, what WACC is and how it is used, what the Modigliani-Miller idea says and why it matters even though its assumptions are unrealistic, and how a company actually settles on its structure. It connects the credit deck to the valuation and LBO decks, and it answers the interview question that follows any DCF: what discount rate, and why.
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Card 1 of 16
What is capital structure?
The mix of debt and equity a company uses to fund its assets.
Capital structure is how a company pays for what it owns: some money borrowed from lenders, which is debt, and some put in by owners or retained from profits, which is equity. Bramwell & Co. with £300m of loans and £700m of shareholders' equity has a capital structure of 30% debt, 70% equity. The mix determines who gets paid first, how much the company must pay out regardless of how it is trading, and what return each provider of money expects. Changing it, by borrowing to buy back shares or issuing shares to repay debt, changes the risk and the value of the company even if the business itself is untouched.
Card 2 of 16
Why is debt cheaper than equity?
Lenders get paid first and get paid a fixed amount, so they take less risk and demand less return; interest is also tax-deductible.
A lender has a contract: interest on set dates, principal back at maturity, and first claim on the assets if the company fails. A shareholder has none of that; she gets whatever is left after everyone else, if anything. Less risk means a lower required return, so debt at 6% is normal when equity investors want 10% or more. On top of that, interest is deducted before corporation tax is calculated, so at a 25% tax rate a 6% loan really costs the company 4.5%. Dividends are paid from taxed profit and get no such relief. Cheaper and tax-advantaged is why companies borrow at all.
Card 3 of 16
If debt is cheaper, why not fund the company entirely with debt?
Because more debt makes both the debt and the equity riskier, and past a point the rising cost of distress outweighs the tax saving.
As a company borrows more, its interest bill rises relative to its profits, and a bad year that was once uncomfortable becomes fatal. Lenders see that and charge more for each additional loan, and shareholders, who now sit behind a bigger pile of claims, demand a higher return too. There are also the costs of financial distress: customers and suppliers pull back from a company that might fail, good staff leave, and management spends its time on the bank rather than the business. At some level of debt those costs grow faster than the tax benefit, and the overall cost of capital starts rising again. That level is the optimal structure.
Card 4 of 16
What is the cost of equity, and how is it usually estimated?
The return shareholders require for the risk they take, typically estimated with the capital asset pricing model.
The cost of equity is the return investors need to be persuaded to hold the company's shares rather than something safer. It is not a cash cost the company pays, like interest, but it is real: if the company earns less than it, the shares fall. The standard estimate is the CAPM: the risk-free rate, usually a government bond yield, plus the company's beta times the equity risk premium. Beta measures how much the shares move with the market; a beta of 1.2 means 20% more volatile than average. With a 4% risk-free rate, a beta of 1.2 and a 5% premium, the cost of equity is 10%.
Card 5 of 16
What is the cost of debt, and why is it taken after tax?
The interest rate the company would pay to borrow today, reduced by the tax relief on interest.
The cost of debt is the rate at which the company could raise new borrowing now, not the rate on loans it took out years ago. It can be read from the yield on its traded bonds, or estimated as the risk-free rate plus the credit spread appropriate to its rating. Because interest is deductible, the effective cost is the rate times one minus the tax rate: a 6% pre-tax cost at 25% tax is 4.5% after tax. That after-tax figure is what goes into WACC, since the tax saving is a real cash benefit of borrowing that the equity does not get.
Card 6 of 16
What is WACC, and what is it used for?
The weighted average cost of capital: the blended return the company must earn on its assets to satisfy both lenders and shareholders, and the discount rate in a DCF.
WACC combines the cost of equity and the after-tax cost of debt, weighted by how much of each the company uses, measured at market values. If Bramwell is 30% debt at 4.5% after tax and 70% equity at 10%, WACC is 0.3 times 4.5 plus 0.7 times 10, which is 8.35%. It is the minimum return the company's investments must earn to create value, so it is the hurdle rate for projects and the discount rate for the company's free cash flows in a DCF. It is the single number an interviewer is most likely to ask you to build from scratch.
Card 7 of 16
Why does WACC use market values of debt and equity rather than book values?
Investors' required returns are on what their claims are worth today, not on what the accounts recorded years ago.
The weights in WACC represent how much of the company's value each investor group owns, and the return they require is a percentage of that value. A company whose shares have risen fivefold since it listed has an equity book value far below its market value; using the book figure would understate the equity weight and the resulting WACC. Debt is usually close to book value unless the bonds trade at a large discount, so the practical difference is on the equity side. For a private company with no market value, analysts estimate it from comparable companies or use a target structure.
Card 8 of 16
What does the Modigliani-Miller theorem say, and why is it useful if its assumptions are unrealistic?
In a world with no taxes or distress costs, capital structure does not change firm value; the theorem tells you that taxes and distress are the whole story.
Modigliani and Miller showed that in a perfect market, with no taxes, no bankruptcy costs and no information problems, the value of a company does not depend on how it is financed. Slicing the same cash flows into debt and equity in different proportions changes who gets what, not the total. Borrowing more raises the cost of equity exactly enough to offset the cheaper debt, so WACC stays flat. Nobody thinks the assumptions hold. The point is what happens when you relax them: the tax deductibility of interest makes debt add value, and the costs of distress make too much debt destroy it. That is the whole modern theory in one sentence.
Card 9 of 16
What is financial leverage, and how does it magnify returns to shareholders in both directions?
Funding assets with debt means the same operating result produces a bigger swing in the return on the owners' smaller stake.
Suppose Ferrow Retail's assets earn 10%. Funded entirely with £100m of equity, shareholders earn 10%. Funded with £50m of equity and £50m of debt at 6%, the assets still earn £10m, the lenders take £3m, and shareholders earn £7m on £50m, which is 14%. Leverage lifted their return. Now suppose the assets earn only 4%: £4m, minus £3m of interest, leaves £1m on £50m, a 2% return, against 4% unlevered. The interest is fixed, so every swing in operating profit lands entirely on the equity. That is why levered equity is riskier and why lenders care about cover.
Card 10 of 16
What is a credit rating, and how does it feed back into capital structure decisions?
An agency's grade for how likely a borrower is to repay; a lower grade means dearer debt, so companies manage their structure to keep a target rating.
Agencies like Moody's and S&P grade companies from AAA down to D on their ability to repay. Investment grade, BBB- and above, means access to the deepest pools of lenders at low spreads; below that is high yield, where borrowing costs jump and some investors cannot buy at all. Because the rating drives the cost of debt, many companies manage their leverage to hold a target, often BBB, and will issue equity or cut dividends rather than lose it. The rating agencies publish the ratios they look at, net debt to EBITDA and interest cover among them, so the target rating becomes a constraint on the whole structure.
Card 11 of 16
What is the pecking order theory, and what does it predict about how companies actually raise money?
Companies prefer retained profits, then debt, then equity as a last resort, because issuing shares signals the shares are overpriced.
The pecking order theory says managers fund investment first from cash the business generates, then by borrowing, and only then by issuing new shares. The reason is information: managers know more than investors, and would only sell shares if they thought the price was full, so an equity issue is read as a signal and the price falls. Debt carries less of that signal because its value depends less on the company's private prospects. The theory predicts that profitable companies carry little debt, because they never need it, which is what you observe, and that share issues are rare and greeted badly, which is also what you observe.
Card 12 of 16
Why do companies in different industries carry such different amounts of debt?
Stable, asset-heavy businesses can borrow a lot; volatile or intangible ones cannot, because lenders want predictable cash and something to seize.
Lenders look for two things: cash flows steady enough to cover interest every year, and assets they could sell if the company failed. Redhill Utilities has both, regulated revenues and a network of pipes and cables, so it can run at five times EBITDA. A software company has neither, its revenue can halve if a product fails and its assets are people and code, so it carries little debt and funds itself with equity. Retailers sit in between, and cyclical businesses like airlines borrow against aircraft but suffer in downturns. When you see a leverage ratio, ask what industry before asking whether it is high.
Card 13 of 16
What is a leveraged recapitalisation, and why would a company do one?
Borrowing a large sum to pay shareholders a special dividend or buy back shares, swapping equity for debt to lower the cost of capital or fend off a bidder.
A leveraged recap is a deliberate change in structure: the company takes on significant new debt and hands the cash to shareholders. The business is unchanged but is now funded with more debt and less equity. Companies do it when they think they are under-levered, because the tax shield on the new debt adds value and the remaining shares are worth more each; or as a defence, because a company already loaded with debt is a less attractive takeover target. The risk is the same as any leverage: if the business then weakens, the debt that looked comfortable becomes a problem. Private equity does the same thing to companies it already owns, called a dividend recap.
Card 14 of 16
Bramwell & Co. is considering funding a £200m acquisition with either new shares or a new loan. What are the arguments each way?
Debt is cheaper and avoids dilution but adds fixed obligations and rating risk; equity is safer but dilutes and signals the shares are full.
Debt: the after-tax cost is lower, so the deal adds more to earnings per share; existing shareholders keep their full stake; and the interest shield adds value. Against it: leverage rises, interest cover falls, the rating agencies may downgrade, and a bad year after the deal is more dangerous. Equity: the balance sheet stays strong and the company keeps borrowing capacity for the next opportunity. Against it: shareholders are diluted, the deal adds less to EPS, and the market may read the issue as management thinking the shares are overpriced. Most companies use a mix, sized to hold their target leverage and rating after the deal.
Card 15 of 16
How does capital structure connect to an LBO?
An LBO is an extreme capital structure choice: fund most of the purchase with debt, use the company's cash to repay it, and let leverage magnify the equity return.
A leveraged buyout is capital structure theory turned into a business model. The private equity buyer funds perhaps 60% of the price with debt secured on the company itself, so its own equity cheque is small. The company's cash flows then pay down that debt over five years or so, which shifts value from lenders to the equity as the debt shrinks. When the company is sold, the equity has grown far faster than the business did, because leverage magnified the return. Everything in this deck applies: the deal only works on a business with steady cash flows, the debt costs more as leverage rises, and too much of it turns a good business into a distressed one.
Card 16 of 16
An interviewer asks: what discount rate would you use for Calder Foods' DCF, and how would you get it? Give the answer in order.
WACC, built from the CAPM cost of equity and the after-tax cost of debt, weighted at market values, with a sentence on each input.
Use WACC, because the free cash flows in a standard DCF belong to all providers of capital. Cost of equity from the CAPM: the current government bond yield as the risk-free rate, a beta from Calder's own share price or from comparable food companies if it is private, and an equity risk premium of around 5%. Cost of debt from the yield on Calder's bonds or the risk-free rate plus a spread for its rating, taken after tax. Weights from the market value of its equity and debt, or a target structure if the current one is unusual. Combine, and say the number, and then say which input you are least sure of, since that is the follow-up.
Reading is not the same as remembering. Study this deck with scheduled review so the cards come back before you forget them.