Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Corporate Issuers - CFA Level I/Capital Structure

Capital Structure

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Cost of Capital and Component Costs6 min

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company must pay to its security holders to finance its assets. It is calculated by weighting the cost of each capital component—equity, preferred stock, and debt—by its proportion in the firm's target capital structure. The cost of debt is the yield to maturity on existing debt, adjusted for the tax shield ($K_d(1-t)$), because interest payments reduce taxable income. If market prices are unavailable, matrix pricing or rating-based approaches are used. The cost of preferred stock is simply the preferred dividend divided by the market price. The cost of equity is more complex and can be estimated using CAPM, which accounts for systematic risk via beta; the Dividend Discount Model (Gordon Growth Model), which relies on dividend forecasts and growth rates; or the bond yield plus risk premium method.

Key Points

WACC is the weighted average of the marginal costs of equity, debt, and preferred stock.
Interest on debt provides a tax shield, reducing the effective cost of debt.
Cost of Equity can be estimated via CAPM, DDM, or Bond Yield + Risk Premium.
Market values, not book values, should be used for determining weights.

Capital Structure Theories: Modigliani-Miller and Trade-Offs6 min

Capital structure theory attempts to explain how firm value changes with the mix of debt and equity. The Modigliani-Miller (MM) Proposition I (No Taxes) states that in a perfect market, a firm's value is independent of its capital structure ($V_L = V_U$). MM Proposition II (No Taxes) adds that the cost of equity increases linearly with leverage, offsetting the benefit of cheaper debt. When corporate taxes are introduced, MM Proposition I changes to suggest that firm value increases with leverage due to the interest tax shield ($V_L = V_U + t \times d$), theoretically maximizing value at 100 percent debt. The Static Trade-Off Theory balances this tax benefit against the costs of financial distress (bankruptcy costs), implying an optimal debt level where firm value is maximized before distress costs erode the tax advantages.

Key Points

MM Prop I (No Taxes): Capital structure is irrelevant to firm value.
MM Prop I (With Taxes): Firm value increases with debt due to the tax shield.
Static Trade-Off Theory: Optimal capital structure balances tax shields vs. financial distress costs.
Financial distress costs reduce the value of levered firms at high debt levels.

Additional Theories and Practical Considerations5 min

Beyond MM and trade-off theories, other frameworks explain financing behavior. The Pecking Order Theory suggests managers prefer internal financing first, followed by debt, and finally equity, to avoid the negative signaling associated with issuing new shares (asymmetric information). The Free Cash Flow Hypothesis argues that high debt levels discipline managers by reducing the free cash flow available for wasteful spending. Floatation costs, the fees paid to investment banks when issuing new securities, should be treated as an initial cash outflow in capital budgeting analysis rather than adjusting the cost of capital. Finally, a firm's life cycle stage impacts its capital structure; start-ups with negative cash flows and high risk rely on equity, while mature firms with predictable cash flows can support higher debt levels.

Key Points

Pecking Order Theory: Internal funds > Debt > Equity.
Signaling: Equity issuance often signals overvaluation, causing stock price drops.
Free Cash Flow Hypothesis: Debt disciplines management by committing cash flow to interest payments.
Floatation costs should be deducted from initial cash flows, not added to the WACC.

Questions

Question 1

Which of the following best describes the Weighted Average Cost of Capital (WACC)?

Capital Structure

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