Definition
Capital structure determines a company's financial risk profile and cost of capital. More debt increases financial leverage (amplifying returns and risks) but provides a tax shield. The optimal capital structure minimizes WACC by balancing the tax benefits of debt against the costs of financial distress. Modigliani-Miller theorem establishes the theoretical framework, while trade-off theory and pecking order theory guide practical decisions.
lightbulb Example
Company A: 30% debt, 70% equity—conservative, lower risk, higher WACC. Company B: 60% debt, 40% equity—aggressive, higher risk, lower WACC due to tax shield. Company B earns higher ROE in good times but faces greater distress risk in downturns.
verified_user Key Points
- Mix of debt and equity financing
- More debt = higher leverage = higher risk + lower WACC (to a point)
- Optimal structure minimizes WACC
- Modigliani-Miller provides theoretical framework