Capital Structure

Earlier lessons addressed a firm’s short-term activities and longer-term capital investment decisions. We now turn to the last part of the balance sheet: long-term debt and equity financing, known as a firm’s capital structure. The first lesson introduces the basic objective of most managers when choosing a capital structure: minimizing the firm’s weighted-average cost of capital. The second lesson considers the internal and external factors that influence a firm’s choice of—and investors’ willingness to offer—debt versus equity financing. While capital structure seems like an important decision for boards and managers, it is the present value of future cash flows, rather than a firm’s capital structure, that primarily drives a firm’s value, a central insight in the influential work of Franco Modigliani and Merton Miller. In the third lesson, we explore the simplifying assumptions used by Modigliani and Miller to demonstrate the irrelevance of capital structure to firm value, and then we relax these assumptions to show the impact of both taxes and the cost of financial distress. In the final lesson, we discuss optimal and target capital structures for issuers.