Capital structure, required returns and financing trade-offs

Learning goals

• Calculate a market-weighted WACC using compatible costs and tax assumptions.
• Contrast idealized Modigliani–Miller results with target structure in an imperfect market.

Draft · approximately 45 minutes, excluding further revision.

Use the opportunity cost of each financing source

For debt and common equity, WACC=wE×rE+wD×rD×(1−Tc) under the stated assumption that interest generates a usable corporate tax deduction. Use economically relevant market-value weights, a forward-looking marginal debt cost and an equity required return consistent with business risk and leverage. A historical coupon is not necessarily the current cost of debt; dividend yield alone is not generally the full cost of equity. Other capital claims require additional compatible terms.

A corporate WACC is not automatically the correct rate for a project with different risk, currency or financing assumptions. Keep nominal/real treatment and cash-flow definitions consistent. Tax rules, deductibility and loss positions vary; the numerical tax factor is a model assumption, not a statement of a company’s legal tax position.

Understand what the ideal model removes

In the no-tax perfect-market Modigliani–Miller benchmark, financing alone does not create firm value. As leverage increases, equity becomes riskier and its required return rises: rE=rU+(rU−rD)D/E in the simple model. WACC remains rU; replacing equity with apparently cheaper debt is not a free value gain. With corporate taxes alone and perpetual debt under simplifying assumptions, debt’s tax shield can add Tc×D to value.

Actual financing decisions balance tax benefits, distress and agency costs, information asymmetry, flexibility, asset collateral and earnings stability. Trade-off reasoning can imply a target range; financing preferences can also reflect information and issuance costs. Optimal structure is model-dependent; a target is an operating policy, not a permanent universal ratio. Rebalancing has costs, and market-value weights drift when security prices change.

Formula and assumptions

WACC=wE×rE+wD×rD×(1−Tc); no-tax MM: rE=rU+(rU−rD)D/E; simple perpetual tax shield=Tc×D

A tax-assumed WACC and a no-tax benchmark

1. Equity market value=600, debt=400, rE=10%, rD=6%, usable tax factor Tc=25%. WACC=0.60×10%+0.40×6%×0.75=7.8%.
2. Separately, in a no-tax MM example rU=10%, rD=5%, D/E=1 implies rE=15%. Equal debt/equity weights then give WACC=0.5×15%+0.5×5%=10%.
3. The two examples use different assumptions. Do not combine their rates or read the tax example as a real company’s approved capital policy.

Calculation lab

Errors to catch

• Using book weights or historical coupons without justification.
• Adding debt while freezing the cost of equity in the no-tax MM model.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.investor.gov