Capital Structure
Capital structure theory
Capital structure tests whether the mix of debt and equity affects cost of capital and firm value. Learn Modigliani-Miller (MM) propositions, the tax shield, financial distress costs, trade-off theory, pecking order and EBIT-EPS analysis.
Core rules
- MM without taxes: firm value is independent of leverage; WACC is constant; homemade leverage substitutes for corporate borrowing.
- MM with corporate tax: value rises by the tax shield, T times D; WACC falls with debt, other things equal.
- In practice, distress and agency costs offset the tax shield, producing a trade-off and a range of optimal gearing.
- Pecking order: internal funds first, then debt, then new equity, because of asymmetric information and issue costs.
- EBIT-EPS indifference identifies the EBIT at which two financing plans give the same EPS.
Worked example
A company needs LKR 5m. Plan A issues 1m shares at LKR 5; existing shares are 2m. Plan B issues debt at 10%, interest LKR 0.5m. Tax is 30%. Indifference: EBIT times 0.7 divided by 3m equals EBIT minus 0.5m, times 0.7, divided by 2m. Cancel 0.7: EBIT/3 = (EBIT - 0.5)/2, so 2EBIT = 3EBIT - 1.5m, EBIT = LKR 1.5m. Above LKR 1.5m, debt gives higher EPS; below it, equity does. EPS is not value: the analysis ignores risk and cash flow.
Traps
Do not apply MM without stating its assumptions; do not add the tax shield without distress costs; do not use book weights; and do not choose debt merely because EPS rises.