Capital Structure in 15 Minutes
Capital structure is the mix of debt and equity a company uses to fund itself. Borrowing can push return on equity up, but it also makes that return riskier. These notes tie together leverage, ROE, the Modigliani-Miller propositions, and why taxes make debt look attractive.
Capital structure explained simply
Capital structure is a company's mix of debt and equity. Borrowing at a rate below what the assets earn pushes return on equity up, but it also makes that return riskier. In the example, 50% debt at 10% lifts ROE from 15% to 20%, but in a bad year (EBIT of $50) levered ROE drops to 0% while the all-equity firm still earns 5%.
What this capital structure lesson covers
- What capital structure means and how debt and equity differ
- How borrowing changes return on investment and return on equity (ROE)
- The core ideas behind M&M Proposition I and Proposition II
- Why the interest tax shield makes debt look attractive
- The real-world trade-off: tax savings vs financial distress costs
Capital structure formulas, explained
- EBIT
- earnings before interest and taxes
- Total assets
- total capital invested in the business (debt + equity)
- Net income
- profit left for shareholders after interest (and taxes)
- Shareholders' equity
- the owners' money invested in the firm
How debt changes ROE step by step (worked example)
A firm has $1,000 of assets and earns EBIT of $150 a year. Compare ROE if it is all-equity financed vs 50% debt at 10% interest. Ignore taxes.
- All equity: net income = $150, equity = $1,000, so ROE = 150 ÷ 1,000 = 15%.
- With 50% debt: debt = $500, interest = 10% × $500 = $50.
- Net income = $150 − $50 = $100; equity = $500.
- Levered ROE = 100 ÷ 500 = 20%.
- Bad year check: if EBIT drops to $50, all-equity ROE = 5% but levered ROE = (50 − 50) ÷ 500 = 0%.
Answer: Debt lifts ROE from 15% to 20% because the firm earns 15% on assets but pays only 10% on debt. The catch: leverage also magnifies bad years, so equity becomes riskier.
All-equity vs 50% debt
| All equity | 50% debt at 10% | |
|---|---|---|
| Equity | $1,000 | $500 |
| ROE in a normal year (EBIT $150) | 15% | 20% |
| ROE in a bad year (EBIT $50) | 5% | 0% |
| Risk to shareholders | Lower | Higher |
How much debt is too much? David's take
Leverage turns good years into better years and bad years into worse ones. Here, a bad year takes the levered firm's ROE to zero. I like to think about it with a soundbite of mine: the road to success has infinite tiny mistakes, some big mistakes and zero vital mistakes. A year of zero ROE is a big mistake you can live with. A level of debt that a bad year turns into bankruptcy is a vital one. So don't ask only how much debt raises ROE. Ask what the worst realistic year does to you.
From David's concept: Choose Your Mistakes. This is David's opinion, alongside the standard textbook answer above.
Harder capital structure questions
At what EBIT do both structures give the same ROE?
When EBIT ÷ 1,000 = (EBIT − 50) ÷ 500, which gives EBIT = $100, a 10% return on assets, exactly the interest rate. Above that, debt helps ROE; below it, debt hurts.
How do taxes change the comparison?
With a 25% tax rate, all-equity ROE becomes 150 × 0.75 ÷ 1,000 = 11.25%, and levered ROE becomes (150 − 50) × 0.75 ÷ 500 = 15%. Interest is deductible, which is one reason debt looks attractive.
Common capital structure questions
What is capital structure in simple terms?
Capital structure is how a company pays for its assets: how much comes from borrowing (debt) and how much from owners (equity). It is usually summarized with ratios like debt-to-equity or debt-to-value, and it affects risk, return on equity, and the cost of capital.
Does debt increase return on equity?
Yes, as long as the business earns more on its assets than it pays in interest. Shareholders keep the spread, so ROE rises. But leverage works both ways: if returns fall below the interest rate, ROE falls faster than it would with no debt.
What did Modigliani and Miller say about capital structure?
In a perfect market with no taxes, M&M showed that firm value does not depend on the debt-equity mix (Proposition I), and that the cost of equity rises with leverage just enough to keep WACC constant (Proposition II). Adding corporate taxes makes debt valuable through the interest tax shield.
What is the optimal capital structure?
There is no single magic ratio. Trade-off theory says firms should borrow until the extra value from interest tax shields is offset by the rising expected costs of financial distress. Stable, profitable firms with tangible assets can usually carry more debt than risky growth firms.