Capital Structure

A company can fund itself entirely with equity, entirely with debt, or with some mix of both. Capital structure is about finding the right mix. Debt is cheaper (interest is tax-deductible; lenders take lower risk than equity holders), but too much debt creates financial distress risk that can destroy value.

The optimal capital structure is the mix that minimises WACC and therefore maximises firm value. In theory (Modigliani-Miller, 1958), in a perfect market with no taxes, capital structure is irrelevant, firm value doesn't change with leverage. Once you introduce taxes and bankruptcy costs, an interior optimum exists.

In practice, Indian companies tend to be less leveraged than their global peers. Sectors like telecom and infrastructure that require large upfront investment are heavily debt-funded. Consumer companies and IT firms often carry minimal debt.

Theoretical frameworks:

Modigliani-Miller Proposition I (no taxes): V_levered = V_unlevered. Capital structure is irrelevant.

MM with taxes: V_levered = V_unlevered + PV(Tax Shield). Debt is valuable because interest is tax-deductible. In an all-debt world, firm value is maximised. But that ignores bankruptcy costs.

Trade-off Theory: Optimal capital structure balances the PV of tax shields against the PV of financial distress costs. The optimal leverage varies by industry:

• Stable cash flows (utilities, consumer staples): can support more debt
• Cyclical / volatile (steel, chemicals, airlines): should carry less debt

Pecking Order Theory (Myers-Majluf): Firms prefer internal funding first, then debt, then equity, because information asymmetry makes equity issuance a signal of overvaluation.

Key leverage metrics:

• Net Debt / EBITDA: How many years of operating earnings to repay net debt. < 3× is generally comfortable for industrial companies.
• Interest Coverage (EBIT / Interest): Should comfortably exceed 2× for investment-grade rating.
• Debt / Equity (D/E): Varies widely by sector.