Capital Structure

Corporate Issuers, LOS weight share 1.1 percent of the 365 Level I learning outcomes.

Corporate IssuersCapital Structure

M-M without taxes says leverage cannot change WACC, and the very next reading says leverage does change WACC once taxes exist, and the exam trusts a candidate to know which world a given question lives in.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. A firm has $400 million in market-value equity and $600 million in market-value debt. Its after-tax cost of debt is 4.8% and its cost of equity is 11.2%. Its WACC is closest to:

Answer: B. WACC = (E/V) x Re + (D/V) x Rd = 0.40 x 11.2% + 0.60 x 4.8% = 4.48% + 2.88% = 7.36%. The cost of debt given is already after-tax, so no further tax adjustment is applied, and the weights must reflect market value, not a simple average.

2. Under Modigliani-Miller Proposition I with no taxes, the value of a firm is determined primarily by:

Answer: B. Proposition I with no taxes holds that firm value depends only on the earning power of its assets, not on the mix of debt and equity used to finance them; splitting the same cash flows differently between debtholders and equityholders does not change their total.

3. Under Modigliani-Miller with corporate taxes but no financial distress costs, as a firm adds more debt, its WACC will most likely:

Answer: B. With taxes and no offsetting distress cost, the interest tax shield makes more debt unambiguously value-adding in the theoretical model, so WACC falls as leverage rises; taken to its logical extreme this framework implies value-maximizing behavior would use as much debt as possible, which is exactly why the model needs to be extended once distress costs are allowed back in.

The lesson

The video lesson for this unit is recorded and waiting to be published. Everything it teaches is written out below.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to calculate WACC from market-value weights and the correct after-tax cost of each capital source, describe what Modigliani-Miller's propositions say with and without taxes, contrast that with trade-off theory's U-shaped WACC, and identify which framework a question is actually testing from its stated assumptions.

WACC blends the cost of every capital source a firm uses, each weighted by its share of total market value: WACC = (E/V) x Re + (D/V) x Rd x (1 - T). A third term, (P/V) x Rp, is added when preferred stock exists. The tax adjustment, (1 - T), applies to debt alone. Interest is tax-deductible; neither preferred nor common dividends are. Applying that adjustment anywhere else is a structural error, not a rounding one. The cost of debt itself is always the current yield to maturity, never the bond's coupon rate. The coupon was fixed at issuance and reflects old conditions. Yield to maturity reflects what a lender demands today, given the bond's actual market price. Weights always use market values, never what was raised in the past; a firm's own stated target capital structure is an acceptable, often preferred, basis alongside current market values.

Modigliani and Miller's Proposition I, in a world with no taxes, no transaction costs, and no distress costs, says a firm's value is completely independent of how it splits financing between debt and equity. Proposition II explains the mechanism behind that result: as a firm substitutes debt for equity, the remaining equity becomes riskier, and its required return rises by precisely enough to leave WACC unchanged. Introduce corporate taxes and the conclusion flips entirely. Because interest is tax-deductible, adding debt now adds value, T x D, to the firm, and left unchecked this framework implies an extreme, unrealistic optimum: maximize debt, all the way to 100 percent. Reading whether a question specifies taxes or no taxes is the single decision that determines which of these two opposite conclusions applies.

Trade-off theory exists precisely because 100 percent debt is not what real firms do. It adds financial distress costs back into the model: firm value equals the unlevered value, plus the present value of the tax shield, minus the expected present value of financial distress costs. The optimal capital structure sits at the point where one more dollar of debt's marginal tax benefit exactly equals its marginal expected distress cost. This produces the shape the exam tests directly: WACC traces a U as leverage rises. It falls at first as cheap, tax-advantaged debt replaces more expensive equity, then rises again once financial distress risk starts to dominate, with the bottom of that U marking the optimal structure. A firm with stable cash flows and collateral-friendly, tangible assets can safely carry more debt before distress costs start to bite; a firm with volatile cash flows and few tangible assets reaches that turning point much sooner.

WACC against leverage, minimized at the optimal structure WACC debt / capital optimal structure
WACC dips as cheap, tax-deductible debt is added, then rises again as financial risk pushes the cost of both debt and equity back up. The dip is the target, not zero debt and not all debt.

Worked in full

A firm's equity has a market value of $600 million and a cost of equity of 11 percent. Its debt has a market value of $400 million and a current yield to maturity of 6.5 percent. The tax rate is 25 percent. What is the firm's WACC? Total market value V = $600M + $400M = $1,000M. Equity weight = 600/1000 = 0.60. Debt weight = 400/1000 = 0.40. After-tax cost of debt = 6.5% x (1 - 0.25) = 4.875%. WACC = (0.60 x 11%) + (0.40 x 4.875%) = 6.6% + 1.95% = 8.55%.

The same problem, one step removed

Same firm: equity $600 million at 11 percent, debt $400 million at a 6.5 percent yield to maturity, tax rate 25 percent. Compute the weights and the after-tax cost of debt yourself, then finish WACC.

The trap

A question naming both taxes and an optimal or moderate capital structure is testing trade-off theory, not pure Modigliani-Miller with taxes: under M-M with taxes and no distress cost added back in, the theoretical implication is maximum debt, never a moderate, balanced level.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. calculate and interpret the weighted-average cost of capital for a company
  2. explain factors affecting capital structure and the weighted-average cost of capital
  3. explain the Modigliani-Miller propositions regarding capital structure
  4. describe optimal and target capital structures

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

WACC weights each capital source by its market value, and applies the tax shield to debt alone

WACC = (E/V) x Re + (D/V) x Rd x (1 - T), where V is total market value of the firm's capital and Rd x (1 - T) is the after-tax cost of debt; a preferred-stock tranche adds a third term, (P/V) x Rp, with no tax adjustment, since neither preferred dividends nor common dividends are tax-deductible. Market-value weights are required over book-value weights because WACC is a forward-looking cost of raising capital today, not a record of past financing.

LOS 01

The cost of debt in WACC is the current yield to maturity, not the bond's coupon rate

A bond's coupon rate was fixed at issuance and reflects historical conditions; the yield to maturity reflects what a lender demands today given the bond's current market price, which is the economically relevant, marginal cost of new debt. Only when a bond trades exactly at par do coupon rate and YTM coincide; otherwise using the coupon rate understates or overstates the true current cost of debt.

LOS 02

M-M Proposition II says cost of equity rises linearly with leverage, exactly offsetting cheaper debt

Without taxes, re_L = re_U + (re_U - rd) x (D/E): as a firm substitutes debt for equity, the remaining equity becomes riskier and its required return rises by precisely enough to leave WACC unchanged, which is the mechanism behind Proposition I's value-invariance result. With taxes, the formula gains a (1 - T) factor that dampens, but does not eliminate, this rising cost of equity.

LOS 02

M-M with taxes and M-M without taxes give opposite predictions for WACC as leverage rises

Without taxes, WACC is flat regardless of capital structure. With taxes, and absent any offsetting distress cost, the interest tax shield (adding T x D to firm value) makes WACC fall as debt rises, implying an extreme, unrealistic conclusion, maximum debt is optimal, that motivates adding financial distress costs back into the model. Reading which assumption set a question specifies, taxes or no taxes, decides which of these two opposite directional answers is correct.

LOS 03

The Modigliani-Miller propositions rest on a specific, named set of simplifying assumptions

The base M-M framework assumes no transaction costs, no taxes (relaxed in the tax version), no costs of financial distress, and that both firms and individual investors can borrow at the same rate, the last of which enables homemade leverage: an investor can replicate any capital structure personally, which is the arbitrage mechanism that forces value equality across differently levered but otherwise identical firms.

LOS 04

Trade-off theory adds financial distress costs back in to produce an interior optimum

Trade-off theory holds that value equals the unlevered firm value plus the present value of the tax shield minus the expected present value of financial distress costs; the optimal capital structure sits where the marginal tax benefit of one more dollar of debt exactly equals the marginal expected distress cost of that dollar. Firms with stable cash flows and tangible, collateral-friendly assets can sustain a higher optimal debt ratio than firms with volatile cash flows or mostly intangible assets, because their expected distress costs are lower at any given leverage level.

LOS 04

A target capital structure is the long-run financing mix a firm aims for, and it is an acceptable weighting basis for WACC

When a firm has a stated or evident target mix of debt and equity, that target is an acceptable, often preferred, basis for WACC weights alongside current market values, since it represents the firm's intended long-run financing structure rather than a snapshot that may be temporarily distorted by market conditions. Book-value weights remain the least preferred basis of the three.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

D/E is not D/(D+E)

A debt-to-equity ratio of 0.5 means debt is one-third of total capital, not one-half. Reading D/E as if it were the debt weight in WACC is the most common arithmetic slip on Proposition II questions.

Coupon is bait; YTM is the answer

The exam routinely supplies both the coupon rate and the current bond price. The coupon rate is the trap; the cost of debt for WACC is always the yield to maturity, then adjusted by (1 - T).

(1-T) touches debt only

Interest is tax-deductible; dividends, preferred or common, are not. Applying (1-T) to a preferred or common equity cost is a structural error, not a rounding one.

No taxes: WACC flat. With taxes, no distress: WACC falls with debt. With distress: WACC is U-shaped

Three distinct frameworks give three distinct answers to what happens to WACC as leverage rises. The exam signals which one applies by explicitly naming its assumptions.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. Identify every capital source in the problem (debt, preferred, common equity) and confirm you have a market value for each.
  2. Convert bond information to a current yield to maturity if only price and coupon are given, then apply (1 - T) to that yield for the after-tax cost of debt; apply no tax adjustment to preferred or common equity.
  3. Compute each component's weight as its market value divided by total market value of all capital sources combined, then sum weight times cost across all components for WACC.
  4. For a Modigliani-Miller question, first identify whether taxes are assumed; the WACC-and-leverage conclusion flips entirely depending on that one assumption.
  5. For an optimal or target capital structure question, connect the answer to the balance between tax shield benefit and expected financial distress cost, not to an arbitrary round-number debt ratio.
  6. [BA II Plus: no direct WACC function; compute each cost component and weight independently, use the bond-price-to-YTM solve (N, PV, PMT, FV, CPT I/Y) for the cost of debt when only price and coupon are given]

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

According to Modigliani and Miller's Proposition I with no taxes, the value of a firm is most likely described as being determined by:

How sure are you?

Correct: B. The correct answer is The cash flows generated by its assets.
A. You might think leverage ratios matter. They do in the real world. Under M-M's perfect market assumptions (no taxes, no distress costs, no asymmetric information), the D/E ratio is irrelevant to firm value.
C. Cost of equity sounds like a key value driver. Cost of equity changes with leverage under Prop II, but WACC and firm value stay constant. Cost of equity is endogenous, not exogenous.

Unit: capital-structure

Question 2Exam level

A firm has an unlevered cost of equity of 10% and a cost of debt of 6%. The firm's debt-to-equity ratio is 0.5. According to M-M Proposition II (no taxes), the firm's levered cost of equity is CLOSEST to:

How sure are you?

Correct: B. The correct answer is 12.0%.
A. Candidates who confuse Prop I and Prop II think cost of equity doesn't change. Prop I says firm VALUE doesn't change, not that cost of equity doesn't change. Prop II explicitly says cost of equity rises with leverage.
C. Using D/E = 0.5 as if it means debt is 50% of total assets (applying to total capital not equity). The D/E ratio is debt divided by equity, not debt divided by total capital. If D/E = 0.5, then D/(D+E) = 0.333, not 0.5.

Unit: capital-structure

Question 3Exam level

Under Modigliani-Miller with corporate taxes, a firm should most likely theoretically:

How sure are you?

Correct: C. The correct answer is Use as much debt as possible to maximize the value of the tax shield.
A. Students know debt carries risk, so they instinctively avoid extreme debt. In the M-M with taxes (but no distress costs) framework, the only effect of debt is the tax shield. There is no offsetting cost, so more debt is always better.
B. This is actually the correct answer under TRADE-OFF THEORY, not M-M with taxes. Trade-off theory adds financial distress costs to create an interior optimum. Under pure M-M with taxes, there is no distress cost. No balancing force.

Unit: capital-structure

Question 4Exam level

According to the trade-off theory of capital structure, the optimal capital structure is most likely where:

How sure are you?

Correct: B. The correct answer is The marginal tax benefit of additional debt equals the marginal cost of financial distress.
A. D/E = 1 sounds like a balanced midpoint. Neither all-debt nor all-equity. The optimal D/E is firm-specific and depends on the tax rate, probability of distress, and magnitude of distress costs. It is not universally 1.0.
C. Low cost of debt sounds optimal. The cost of debt is determined by credit risk, not chosen by management. The optimal capital structure is about the balance of benefits and costs, not about achieving a particular interest rate.

Unit: capital-structure

Question 5Exam level

A company's CFO argues that issuing equity would signal to the market that the stock is overvalued. This reasoning is MOST consistent with which capital structure theory?

How sure are you?

Correct: C. The correct answer is Pecking order theory.
A. M-M Prop I talks about capital structure being irrelevant, so it seems like a logical frame. M-M assumes perfect information. No asymmetric information. Prop I says how you finance doesn't matter, not that market signals exist.
B. Trade-off theory is mentioned frequently and seems like a catch-all. Trade-off theory is about taxes vs. distress costs. It says nothing about signaling effects or information asymmetry.

Unit: capital-structure

Question 6Exam level

Which of the following is most likely NOT an assumption of the original Modigliani-Miller framework (no taxes)?

How sure are you?

Correct: C. The correct answer is Corporate tax rates are positive.
A. Transaction costs seem like a real-world complication that might not be in a simple model. Absence of transaction costs IS one of the M-M assumptions. The question asks what is NOT an assumption, and 'no transaction costs' IS assumed.
B. Risk-free borrowing sounds unrealistic, so candidates think it might be excluded. M-M assumes individuals and corporations can borrow at the same risk-free rate. This IS one of the assumptions.

Unit: capital-structure

Question 7Exam level

Firm A is unlevered with a value of $50 million. The corporate tax rate is 30%. If the firm issues $20 million of debt and uses proceeds to repurchase equity, the value of the levered firm under M-M with taxes is closest to:

How sure are you?

Correct: C. The correct answer is $56.0 million.
A. Candidates who remember Prop I (no taxes) conclude firm value doesn't change with leverage. Prop I with NO TAXES says value is unchanged. This question specifies taxes, which changes the result. The tax shield adds T*D to firm value.
B. Computing 30% of $50M instead of 30% of $20M: 0.30 x $50M = $15M... no, actually 50+4=54 suggests using 20% of $20M or some other arithmetic error. The formula is T*D where D is the amount of debt issued ($20M), not the total firm value ($50M).

Unit: capital-structure

Question 8Exam level

Under M-M Proposition II without taxes, as a firm most likely increases its financial leverage, its weighted average cost of capital (WACC) will:

How sure are you?

Correct: C. The correct answer is Remain constant, because the increase in cost of equity exactly offsets the lower cost of debt.
A. More financial risk should increase the hurdle rate. This is real-world intuition. Under M-M no-tax perfect markets, the rise in equity cost exactly compensates. The blended rate stays flat. Financial risk affects equity cost but not WACC.
B. Debt is cheaper than equity, so substituting equity for debt should reduce WACC. As you substitute debt for equity, equity becomes riskier and its required return rises. The 'cheap' debt advantage is exactly cancelled by 'more expensive' equity.

Unit: capital-structure

Question 9Above the exam

A firm operates with an all-equity capital structure worth $50 million (Modigliani-Miller Proposition I, no taxes, assumed to hold). The firm then issues $20 million of debt and uses the proceeds to repurchase equity, with no change in operating cash flows. Combining MM Proposition I (no taxes) with MM Proposition II (no taxes), the firm's WACC after the recapitalization is most likely to:

How sure are you?

Correct: B. Under MM Proposition I (no taxes), total firm value, and therefore WACC, is unaffected by capital structure. MM Proposition II explains the mechanism: as leverage increases, the cost of equity rises linearly to compensate equity holders for the additional financial risk they now bear, and this rising cost of equity exactly offsets the effect of weighting more of the capital structure toward cheaper debt, leaving WACC unchanged at every leverage level.
A. Debt being cheaper than equity does not, by itself, change WACC under the MM (no taxes) framework, because Proposition II shows the cost of equity rises just enough to offset using more of that cheaper debt; assuming WACC rises ignores this exact offsetting mechanism the two propositions describe together.
C. The intuitive appeal of 'more cheap debt lowers the average cost' is exactly the trap MM Proposition II is built to correct: the RISING cost of equity as leverage increases exactly cancels out the weighting effect, which is why MM (no taxes) concludes WACC is invariant to capital structure, not decreasing with more debt.

Unit: capital-structure

Question 10Above the exam

A firm operates in a world with corporate taxes (MM with taxes) and is currently unlevered with a firm value of $80 million and a 25% corporate tax rate. It is considering issuing $30 million in permanent debt and using the proceeds to repurchase equity. Combining MM Proposition I with taxes with the interest tax shield concept, the levered firm's value is most likely closest to:

How sure are you?

Correct: B. Under MM Proposition I WITH corporate taxes, levering up creates value through the interest tax shield: VL = VU + (tax rate x Debt) for permanent debt. Here VL = $80 million + (0.25 x $30 million) = $80 million + $7.5 million = $87.5 million. This is a combined-concept item: the NO-TAX version of Proposition I says capital structure is irrelevant, but once taxes are introduced, debt creates real value through the deductibility of interest expense.
A. The 'capital structure is irrelevant' result is specifically the NO-TAX version of MM Proposition I; once corporate taxes are introduced, debt financing creates real value through the interest tax shield, so firm value is NOT unchanged by the recapitalization in this scenario.
C. Simply adding the full face value of new debt to firm value overstates the effect; only the TAX SHIELD portion of the debt (tax rate x debt amount), not the full principal amount itself, adds to firm value under MM with taxes; the debt is proceeds used to repurchase equity, not new capital added to the firm's asset base.

Unit: capital-structure

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