Corporate Finance and Capital Structure
This domain tests financing decisions and how capital structure affects cost of capital and shareholder returns. Expect numerical questions on leverage, WACC and EBIT-EPS, plus conceptual questions on dividend and financing theory.
Core concepts
- Debt is cheaper pre-tax because interest is deductible; dividends are not.
- WACC is the weighted average of after-tax cost of debt and cost of equity at market weights.
- MM without taxes: firm value is independent of leverage. With taxes: value rises by the tax shield, but distress and agency costs offset it.
- Pecking order: internal funds, then debt, then equity.
- Operating leverage (fixed costs) versus financial leverage (fixed financing costs).
Worked example
A company needs ₹10 crore. Plan A: 1 crore shares at ₹10. Plan B: 50 lakh shares at ₹10 plus ₹5 crore debt at 10%, interest ₹50 lakh. Tax is 25%. Indifference EBIT solves 0.75 EBIT / 1 crore = 0.75(EBIT − ₹0.5 crore) / 0.5 crore. Cancelling 0.75: EBIT = 2(EBIT − 0.5), so EBIT = ₹1 crore. At ₹1 crore both plans give EPS of ₹0.75. Above ₹1 crore, Plan B gives higher EPS; below, Plan A is safer.
Traps
- Using book weights when the question gives market values.
- Forgetting the tax shield in cost of debt: use Kd(1 − t).
- Assuming more debt always lowers WACC; financial distress can raise it.
- Treating principal repayment as tax-deductible; only interest is.
- Mixing operating and financial leverage in one calculation.