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Capital structure

In this chapter: Modigliani-Miller propositions · Trade-off and pecking-order theories

~3 min readLayer 4 · Professional CertificationsFree

Capital structure = mix of debt and equity. Modigliani-Miller (1958): in perfect markets without taxes, capital structure is irrelevant. Add taxes → debt creates tax shield. Add bankruptcy costs → too much debt risks default.

Foundation

Modigliani-Miller insights: • MM Proposition I: firm value independent of capital structure (perfect markets, no taxes) • MM Proposition II: WACC constant (cost of capital invariant) Add taxes: debt creates tax shield (interest deductible). Now debt favorable. Add bankruptcy costs: too much debt risks default. Limits debt. Trade-off theory: optimal D/E balances tax shield against bankruptcy costs. Pecking order: firms prefer internal funds, then debt, then equity (last resort).

Deep Dive

Worked: firm with ₹100 cr operating earnings, 30% tax. Unlevered (no debt): tax = ₹30 cr, NI = ₹70 cr. Levered with ₹500 cr debt at 8% (interest = ₹40 cr): tax = (100−40)×0.30 = ₹18 cr, NI = ₹42 cr to equity. Tax savings = ₹12 cr per year. Capitalised value of tax shield = D × tax rate = ₹150 cr (perpetuity). Indian sector D/E benchmarks: • PSU banks: 10-12× (deposit-funded) • Private banks: 6-8× • Metals/cement: 0.5-1.5× • FMCG: 0.1-0.3× • IT: 0.0-0.1× (often net cash) • Telecom: 1.5-3× • Pharma: 0.2-0.5× Use industry-relative ratios.

Advanced

Beyond debt-to-equity: • Interest Coverage (EBIT/Interest) • Debt-to-EBITDA • FFO-to-Debt for credit analysis Coverage <2: distress; <4: watch; >6: comfortable. Practitioner: capital structure changes signal management views. • Buybacks: cash-generative + undervalued or limited reinvestment • Debt-funded buybacks: aggressive • Equity issuance: often signals overvaluation Pecking order explains why firms accumulate cash even when interest rates low — managers prefer financial flexibility (no need to access markets at adverse times).

Regulatory references
  • MM 1958 paper
  • CFA Institute curriculum
  • SEBI takeover regulations
Common mistakes & pitfalls
  • Static thinking about capital structure.
  • Comparing across industries inappropriately.
  • Ignoring industry-specific norms.

Frequently asked

Why don't IT companies use debt?
Cash flow strong; equity-light business; no need for debt. Pecking order: internal cash first. Debt provides minimal benefit; bankruptcy costs not zero. Stay debt-free.
How to identify optimal capital structure?
Industry-relative + firm-specific risk. Rated firms: BBB-rated D/E typical for sector. Below BBB: overlevered.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
Modigliani-Miller proposition I (no taxes):
  1. (a)Capital structure matters
  2. (b)Firm value independent of capital structure
  3. (c)Debt always preferred
  4. (d)Equity always preferred
Correct: (b) Firm value independent of capital structure
MM I: in perfect markets without taxes, firm value invariant to capital structure. Foundational insight.
Q 2
Tax shield value (perpetuity):
  1. (a)D × interest rate
  2. (b)D × tax rate
  3. (c)D × growth rate
  4. (d)No tax shield
Correct: (b) D × tax rate
Tax shield = D × tax rate. Capitalised value of perpetual interest tax savings.
Q 3
IT companies typical D/E:
  1. (a)5×
  2. (b)0.0-0.1×
  3. (c)2-3×
  4. (d)10×
Correct: (b) 0.0-0.1×
IT services: capital-light, cash-rich. D/E typically 0.0-0.1×. Often net cash position.
Q 4
Pecking order theory says firms prefer:
  1. (a)External equity first
  2. (b)Internal funds → debt → equity (last resort)
  3. (c)Debt always
  4. (d)Random funding
Correct: (b) Internal funds → debt → equity (last resort)
Pecking order: internal funds first (no transaction cost), then debt (lower cost), then equity (last resort).
Q 5
Indian PSU bank D/E typically:
  1. (a)Less than 1
  2. (b)8-12× (deposit-funded)
  3. (c)20×
  4. (d)0
Correct: (b) 8-12× (deposit-funded)
PSU banks: deposit-funded structure means high D/E (8-12× equity). Standard for banking. Different from non-bank firms.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.