Capital Structure Strategy

The first two chapters covered how to raise equity and debt separately. This chapter covers the actual decision sitting above both: how much of each a company should have, and why — the real strategic question a DCM or ECM banker (and a company's own CFO) is ultimately trying to answer.

The core trade-off: cost vs. risk

Debt is generally cheaper than equity as a source of capital, for two real reasons: interest payments are tax-deductible (equity dividends are not, in most jurisdictions), and debt holders take less risk than equity holders (they get paid first, and a fixed amount), so they demand a lower return. But more debt means more fixed, mandatory payments — regardless of how the business actually performs — which raises real financial distress risk if cash flow falls short. Equity is more expensive but far more flexible: no obligation to pay a dividend in a bad year.

WACC — minimizing the blended cost of capital

Finance 101 introduced WACC as the discount rate in a DCF. From a company's own perspective, WACC is also the actual, real cost of the capital it uses to fund itself — and a genuine strategic goal is often to find the capital structure that minimizes WACC, since a lower WACC directly increases the present value of the company's own future cash flows (the same DCF math, run in reverse).

Worked example: a company is currently funded 100% by equity, with a cost of equity of 12%. WACC = 12% (no debt weight). If it instead takes on debt equal to 30% of its capital structure, at a 6% pre-tax cost of debt (25% tax rate, so after-tax cost of debt = 6% × (1 − 25%) = 4.5%), and its cost of equity rises slightly to 13% (reflecting the added financial risk from leverage):

• WACC = (70% × 13%) + (30% × 4.5%) = 9.1% + 1.35% = 10.45%.
• This is lower than the original 12% all-equity WACC — the tax-deductibility of debt and its lower required return more than offset the modest rise in the cost of equity, at this leverage level.

Why this doesn't mean "more debt is always better"

Push leverage high enough, and the relationship reverses: the cost of equity keeps rising faster (equity holders demanding much more compensation for the escalating risk of a highly-levered company), and eventually credit rating downgrades (the DCM chapter's worked example) push the cost of debt up sharply too — both effects can eventually push WACC back up, not down. There's a real, if company-specific and not perfectly precise, "optimal" capital structure in between — too little debt leaves a cheaper financing tool on the table; too much debt raises the real cost of both debt and equity simultaneously, and raises genuine bankruptcy risk.

Hybrid instruments — not always a binary choice

Companies don't have to choose purely between plain debt and plain equity. Convertible bonds (debt that can convert into equity under specified conditions) and preferred stock (equity-like, but often with a fixed dividend and priority over common equity) sit between the two, letting a company access capital at a blended cost and risk profile — genuinely useful tools for a company whose ideal financing doesn't fit neatly into either pure category.