Every company must decide how to finance its operations and growth. The mix of debt, equity, and other financing sources a company uses is called its capital structure. Getting this mix right is one of the most important strategic decisions management and the board can make, as it directly affects shareholder returns, financial flexibility, and the company’s ability to survive economic downturns.

Capital structure optimization involves finding the right balance between the benefits of debt (primarily tax shields and leverage) and the risks of financial distress. The foundational work on this topic came from Franco Modigliani and Merton Miller, whose Nobel Prize-winning research established that in a world without taxes and transaction costs, capital structure would be irrelevant to firm value. In the real world, however, taxes and other market imperfections make these decisions critical.¹

Understanding Capital Structure Basics

Capital structure describes how a company finances its overall operations and assets through various sources of funds. The two primary categories are debt (borrowed money that must be repaid with interest) and equity (ownership stakes that don’t require repayment but share in profits and losses). Most companies use a combination of both, along with retained earnings from past profits.

The capital structure appears on the right side of a company’s balance sheet. Total capitalization includes long-term debt, preferred stock, and common equity (common stock plus retained earnings). You can find this information in a company’s annual report (Form 10-K) filed with the Securities and Exchange Commission. Short-term debt is sometimes included in capital structure analysis, particularly for companies that routinely roll over short-term borrowings.

Financial analysts commonly measure capital structure using leverage ratios. The CFA Institute’s corporate finance curriculum identifies the debt-to-equity ratio as dividing total debt by shareholders’ equity, showing how much debt the company uses relative to owner investment. The debt-to-capital ratio expresses debt as a percentage of total capitalization. Higher ratios indicate more aggressive use of leverage.²

The Benefits and Costs of Debt Financing

Debt financing offers several advantages that make it attractive to corporations. The most significant is the tax deductibility of interest payments. Because interest expenses reduce taxable income, the after-tax cost of debt is lower than the stated interest rate. According to IRS guidelines on business interest expense, a company paying 6% interest in the 25% tax bracket has an after-tax cost of debt of only 4.5%.

Debt also provides financial leverage, which can amplify returns to shareholders. When a company earns more on its investments than it pays in interest, the excess returns flow entirely to equity holders. This magnification effect works in both directions, however, meaning losses are also amplified when the company underperforms.³

Financial distress costs

The primary cost of debt financing is the risk of financial distress. Companies with high debt levels must make fixed interest and principal payments regardless of business conditions. If cash flows decline unexpectedly, the company may struggle to meet these obligations, potentially leading to default, bankruptcy, or forced asset sales at unfavorable prices.

Financial distress creates both direct and indirect costs. Direct costs include legal fees, court costs, and professional fees during bankruptcy proceedings. The United States Courts bankruptcy statistics show that Chapter 11 reorganizations can take years to resolve. Indirect costs can be even larger: customers may defect to competitors, suppliers may demand unfavorable terms, and talented employees may leave for more stable employers. These costs reduce firm value and harm shareholders.

Agency costs of debt

Debt also creates agency costs arising from conflicts between shareholders and creditors. Because equity holders receive residual claims after debt is repaid, they may prefer riskier strategies that could pay off handsomely but might also lead to default. Creditors recognize this incentive and protect themselves through restrictive covenants that limit management’s flexibility.

Common debt covenants include restrictions on additional borrowing, requirements to maintain certain financial ratios, and limitations on dividend payments or asset sales. While these protections benefit creditors, they reduce the company’s strategic flexibility and may prevent value-creating transactions.⁴

Equity Financing Considerations

Equity financing involves selling ownership stakes in the company. Unlike debt, equity does not require repayment or fixed periodic payments. Shareholders receive returns through dividends (at the board’s discretion) and capital appreciation if the stock price rises. This flexibility makes equity financing attractive during uncertain times or for companies with volatile cash flows.

The primary cost of equity is dilution. When a company issues new shares, existing shareholders see their ownership percentage decrease. Companies must register equity offerings with the SEC through either a Form S-1 registration statement for initial public offerings or follow-on offerings. If the new shares are issued at a price below intrinsic value, existing shareholders experience wealth transfer to new investors. This concern makes companies cautious about equity issuance, particularly when they believe their stock is undervalued.

Cost of equity capital

Equity capital is generally more expensive than debt on an after-tax basis. Shareholders bear more risk than creditors because they receive payment only after all debt obligations are satisfied. They demand higher expected returns to compensate for this additional risk. The cost of equity typically ranges from 8% to 15% for established companies, compared to after-tax debt costs often below 5%.

Companies estimate their cost of equity using models like the Capital Asset Pricing Model (CAPM), developed by Nobel laureate William Sharpe, which relates expected returns to systematic risk measured by beta. Companies with higher betas have higher costs of equity because their returns are more sensitive to overall market movements.⁵

Signaling effects

Equity issuance often sends negative signals to the market. Because managers have better information about firm value than outside investors, a decision to issue equity may suggest management believes the stock is overvalued. Research shows that stock prices typically decline on announcement of new equity offerings, reflecting this information asymmetry.

This signaling effect creates a “pecking order” in financing preferences. Companies generally prefer internal financing (retained earnings) first, then debt, and equity only as a last resort. Understanding this hierarchy helps explain why profitable companies often have low debt levels: they simply don’t need external financing.⁶

Hybrid Securities: Combining Debt and Equity Features

Hybrid securities blend characteristics of both debt and equity, allowing companies to fine-tune their capital structures. The most common hybrid instruments are convertible bonds, preferred stock, and various warrant structures. These securities can help companies access capital markets when traditional debt or equity might be unattractive.

Convertible bonds

Convertible bonds start as debt instruments but can be converted into common stock at the holder’s option. They pay regular interest like traditional bonds but offer the upside potential of equity participation. The Financial Industry Regulatory Authority (FINRA) notes that companies issue convertibles because they carry lower interest rates than straight debt, reflecting the value of the conversion option.

From the company’s perspective, convertibles offer a way to issue equity at a premium to current market prices. If the stock rises above the conversion price, bondholders will convert, and the company will have effectively issued stock at that higher price. If the stock remains below the conversion price, the convertibles function like ordinary debt with below-market interest rates.⁷

Preferred stock

Preferred stock occupies a position between debt and common equity in the capital structure. Preferred shareholders receive dividends before common shareholders and have priority in liquidation, but they typically lack voting rights. Unlike interest on debt, preferred dividends are not tax-deductible, making preferred stock more expensive than debt from a corporate perspective.

Despite its tax disadvantage, preferred stock serves important purposes. The Federal Reserve’s bank capital requirements allow banks and insurance companies to count certain preferred stock toward regulatory capital. For corporate issuers, preferred stock offers flexibility because missed dividend payments do not trigger default (though cumulative preferred requires payment of all missed dividends before common dividends can resume).

Finding the Optimal Capital Structure

The optimal capital structure is the mix of financing that minimizes the company’s weighted average cost of capital (WACC) while maintaining adequate financial flexibility. WACC represents the blended cost of all capital sources, weighted by their proportions in the capital structure. Lower WACC means higher firm value, all else equal.

In theory, companies should add debt as long as the tax benefits exceed the expected costs of financial distress. At low debt levels, distress costs are minimal and tax benefits dominate. As leverage increases, the probability and expected costs of distress rise until they eventually exceed incremental tax benefits. The optimal point balances these competing effects.⁸

Industry and business model considerations

Optimal capital structure varies significantly across industries and business models. Companies with stable, predictable cash flows can safely use more leverage. Utilities and real estate investment trusts (REITs) typically carry high debt loads because their revenues are relatively steady and predictable.

Conversely, companies in cyclical or rapidly changing industries generally use less debt. Technology companies often carry little or no debt because their cash flows are uncertain and their business models can change quickly. Pharmaceutical companies may maintain low leverage to preserve financial flexibility for acquisitions and research investments.

Credit rating implications

Credit ratings from agencies like Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings significantly influence capital structure decisions. Higher leverage typically results in lower credit ratings, which increases borrowing costs and may limit access to certain capital markets. Many companies target specific credit ratings and manage their capital structures accordingly.

Investment-grade ratings (BBB-/Baa3 or higher) provide access to the most liquid credit markets and the lowest borrowing rates. Companies may sacrifice potential value from higher leverage to maintain investment-grade status, particularly if they need reliable market access for refinancing or growth capital.⁹

Capital Structure in Practice

Real-world capital structure decisions involve considerations beyond pure optimization. Management teams consider current market conditions, investor preferences, competitive positioning, and strategic flexibility. The theoretical optimal capital structure provides a target, but practical implementation requires judgment and adaptability.

Companies often establish target debt-to-capital ranges rather than precise targets. This approach provides flexibility to deviate temporarily for strategic reasons while maintaining discipline over the long term. Share repurchases funded by debt have become a common way to move toward higher leverage targets, returning excess capital to shareholders while capturing tax benefits.

Private equity firms demonstrate aggressive capital structure optimization in action. They typically finance acquisitions with 50% to 70% debt, far higher than most public companies. This extreme leverage amplifies returns when deals succeed but contributes to failures when portfolio companies cannot service their debt during downturns.

The Bottom Line

Capital structure optimization is both an art and a science. While financial theory provides frameworks for thinking about the trade-offs between debt and equity, practical decisions require balancing multiple considerations, including tax efficiency, financial flexibility, credit quality, and strategic priorities.

For investors, understanding a company’s capital structure provides insight into management’s risk tolerance and financial strategy. Companies that maintain conservative capital structures prioritize stability and flexibility, while those using aggressive leverage are betting on consistent performance to generate superior returns. Neither approach is inherently right or wrong, but the capital structure should align with the company’s business model, competitive position, and growth objectives.

Sources

1. Modigliani, F. and Miller, M. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 1958.
2. CFA Institute. “Corporate Finance.” CFA Program Curriculum, 2024.
3. Berk, J. and DeMarzo, P. “Corporate Finance.” Pearson, 5th Edition, 2020.
4. Jensen, M. and Meckling, W. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics, 1976.
5. Sharpe, W. “Capital Asset Prices: A Theory of Market Equilibrium.” Journal of Finance, 1964.
6. Myers, S. and Majluf, N. “Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have.” Journal of Financial Economics, 1984.
7. Brennan, M. and Schwartz, E. “Analyzing Convertible Bonds.” Journal of Financial and Quantitative Analysis, 1980.
8. Graham, J. “How Big Are the Tax Benefits of Debt?” Journal of Finance, 2000.
9. S&P Global Ratings. “General Criteria: Corporate Methodology.” S&P Global, 2023.