Capital Structure: Theory, Policy and the Financing Decision

Learning objectives

By the end you can:

1. Prove Modigliani and Miller's Proposition I without taxes by constructing the homemade-leverage arbitrage in both directions, and state the four assumptions the proof consumes.
2. Compute the levered cost of equity and the weighted average cost of capital at three or more leverage levels under MM Proposition II without taxes, and show that the cost of equity rises exactly fast enough to leave the weighted average flat.
3. Price the corporate tax shield, compute the levered value, the levered cost of equity and the weighted average cost of capital with taxes, and verify each by an independent route.
4. Reconcile the levered cost of equity to the Hamada relation, carry a non-zero debt beta through it, and quantify in basis points the error that assuming a zero debt beta introduces.
5. Work the Miller equilibrium in both tax regimes, compute the net gain per unit of debt after personal taxes, find the corporate rate at which that gain vanishes, and say why the sign of the answer is not robust to its inputs.
6. Build a static trade-off curve numerically: solve the coverage-to-spread fixed point, apply a stated distress-probability schedule and distress-cost fraction, locate the interior optimum, and quantify how flat the curve is near it.
7. Quantify the agency cost of equity using the free-cash-flow argument, and the two agency costs of debt (asset substitution and debt overhang) with payoff tables that show who gains, who pays, and how much simply evaporates.
8. State the pecking order's prediction for an equity issue, convert the announcement effect into money on a stated market capitalisation, and reconcile the ordering of financing sources with the ordering of capital uses without contradicting either.
9. Solve the EBIT-EPS indifference point algebraically, tabulate earnings per share under a debt plan and an equity plan across a range of operating profit, and demonstrate that maximising earnings per share and maximising value per share are different objectives that disagree.
10. Read a financing decision as a signal: name the average announcement effect of an equity issue, a debt issue, a buyback and a dividend initiation, size each in money, and say what an analyst may and may not infer from one.

Prerequisites & connections

Builds on. M3.03 owns the cost of capital: the risk-free rate, the bottom-up beta, the Hamada unlever-and-relever recipe, the synthetic-rating table that maps interest coverage to a credit spread, and the marginal-tax convention (India about 25.17%, the United States about 25% once state tax is added). This node borrows all of it, states nothing about beta estimation, and adds only the reason the Hamada relation is true and the correction it needs when the debt beta is not zero. M3.07 owns capital allocation: the conservation-of-value principle, the five uses of capital, and the proof that a buyback creates value only below intrinsic value. M2.02 owns the coverage and solvency ratios that feed the rating lookup. EC1.02 owns dividend policy, the Modigliani and Miller 1961 dividend-irrelevance baseline, share classes and index construction. E11.01 owns the credit lens: rating methodology, covenants, the recovery waterfall under Section 53 of the Insolvency and Bankruptcy Code, and the spread-equals-probability-times-loss slide rule. M4.01 owns the degree of operating leverage, the degree of financial leverage and their product.

Deliberate non-overlaps. Do not rebuild any of the above. The synthetic-rating table is used here as a lookup and is not re-derived; where a spread appears, M3.03's table produced it. The value arithmetic of a buyback belongs to M3.07 and is cited rather than repeated; what is added here is the leverage side of the same transaction, meaning the tax shield the borrowing creates and the distress cost it imports. Covenant drafting and the insolvency waterfall belong to E11.01; what is added here is the payoff table that shows why a covenant is worth paying for. Dividend policy belongs to EC1.02; what is added here is dividends read as a signal about private information, alongside the other three financing announcements. M4.01 owns the degree of financial leverage as a sensitivity measure; the EBIT-EPS indifference point taught here is the decision rule that sits on top of it.