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LM06 Capital Structure 2025 Level I Notes © IFT. All rights reserved 1 LM06 Capital Structure 1. Introduction ........................................................................................................................................................... 2 2. The Cost of Capital ............................................................................................................................................... 2 3. Factors Affecting Capital Structure ............................................................................................................... 3 Determinants of the Amount and Type of Financing Needed ........................................................... 3 Determinants of the Costs of Debt and Equity ........................................................................................ 6 4. Modigliani–Miller Capital Structure Propositions .................................................................................. 7 Capital Structure Irrelevance (MM Proposition I without Taxes) ................................................... 7 Higher Financial Leverage Raises the Cost of Equity (MM Proposition II without Taxes) .... 8 Firm Value with Taxes (MM Proposition II with Taxes) ..................................................................... 9 Cost of Capital (MM Proposition II with Taxes) ...................................................................................... 9 Cost of Financial Distress ..............................................................................................................................10 5. Optimal Capital Structure ..............................................................................................................................10 Target Weights and WACC ...........................................................................................................................12 Pecking Order Theory and Agency Costs ...............................................................................................13 Summary ...................................................................................................................................................................15 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM06 Capital Structure 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Calculating and interpreting the weighted-average cost of capital (WACC) for a company  Factors affecting capital structure  Modigliani–Miller propositions regarding capital structure  Optimal and target capital structure 2. The Cost of Capital Cost of capital is the rate of return that the suppliers of capital require as compensation for their contribution of capital. Assume a company decides to build a steel plant and needs money or capital for it. Investors such as bondholders or equity holders will lend this capital to the company. Suppliers of capital will be motivated to part with their money for a certain period of time if the money invested can earn a greater return than it would earn elsewhere. In short, investors will invest if the return (IRR) is greater than the cost of capital. A company has access to several sources of capital such as issuing equity, debt, or instruments that share characteristics of both debt and equity. Each source becomes a component of the company’s funding and has a specific cost associated with it called the component cost of capital. The cost of capital is the rate of return expected by investors for average-risk investment in a company. Investors will demand a higher rate of return for higher-than-average-risk investments. Similarly, investors will demand a lower rate of return for lower-than-average- risk investments. One way of calculating this cost is to determine the weighted average cost of capital (WACC), which is also called the marginal cost of capital. It is called marginal because it is the additional or incremental cost a company incurs to issue additional debt or equity. Three common sources of capital are common shares, preferred shares, and debt. WACC is the cost of each component of capital in the proportion they are used in the company. WACC = wdrd (1 − t) + wprp + were where: wd = proportion of debt that the company uses when it raises new funds rd = before-tax marginal cost of debt t = company’s marginal tax rate wp = proportion of preferred stock the company uses when it raises new funds rp = marginal cost of preferred stock we = proportion of equity that the company uses when it raises new funds re = the marginal cost of equity
LM06 Capital Structure 2025 Level I Notes © IFT. All rights reserved 3 The weights are the proportions of the various sources of capital that the company uses. The weights should represent the company’s target capital structure and not the current capital structure. For example, suppose that current capital structure of a company is 33.3% debt, 33.3% preferred stock and 33.3% common stock. To fund a new project, the company plans to issue more debt and its capital structure will change to 50% debt, 25% preferred stock, and 25% common stock. WACC calculations should be based on these new weights, i.e., the target weights. Example IFT has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60 percent equity. IFT wants to maintain these weights as it raises additional capital. Interest expense is tax deductible. The before-tax cost of debt is 8 percent, cost of preferred stock is 10 percent, and cost of equity is 15 percent. If the marginal tax rate is 40 percent, what is the WACC? Solution: WACC = (0.3) (0.08) (1 - 0.4) + (0.1) (0.1) + (0.6) (0.15) = 11.44 percent Note: Before-tax cost of debt is given. Do not forget to calculate the after-tax cost. Example Machiavelli Co. has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent. Machiavelli Co. intends to maintain its current capital structure as it raises additional capital. In making its capital budgeting decisions for the average risk project, what is the relevant cost of capital? Solution: The relevant cost of capital is 7%. The WACC using weights derived from the current capital structure is the best estimate of the cost of capital for the average risk project of a company. 3. Factors Affecting Capital Structure Capital structure refers to the specific mix of debt and equity a company uses to finance its assets and operations. Issuers desire a capital structure that minimizes their weighted- average cost of capital and generally matches the duration of their assets. Determinants of the Amount and Type of Financing Needed The total amount and type of financing needed usually depends on the issuer’s business model and its position in the corporate life cycle. Corporate Life Cycle A company’s life cycle stage influences its cash flow characteristics, its ability to support
LM06 Capital Structure 2025 Level I Notes © IFT. All rights reserved 4 debt; and is therefore a primary factor in determining capital structure. Any capital that is not sourced through borrowing must come from equity. As companies mature and move from start-up, through growth, to maturity, their business risk typically declines, and their operating cash flows turn positive and become more predictable. This allows for greater use of leverage at more attractive terms. This is illustrated in Exhibit 2 from the curriculum. Start-Ups  In this stage a company’s revenues are close to zero and a lot of investment is required to move from the prototype stage to commercial production.  Therefore, cash flow is usually negative.  The risk of business failure is high.  The company typically raises capital through equity rather than debt.  Equity is generally sourced through private markets (venture capital) rather than public markets.  Debt is generally not available or is very expensive. It is usually a negligible component of the capital structure.  Some start-ups may be able to raise convertible debt.