Cost of Capital and Capital Structure

Introduction and Context

Investment banking and corporate finance decisions are fundamentally decisions about allocating capital under uncertainty. A firm may raise funds through ordinary shares, preference shares, retained earnings, bonds, bank loans, leases, or hybrid securities. Each source has a price, a risk profile, contractual conditions, and consequences for control and financial flexibility. The cost of capital is the required return demanded by providers of finance. Capital structure is the mix of debt and equity used to finance the firm’s assets and operations.

These concepts are central to valuation, mergers and acquisitions, project finance, restructuring, leveraged buyouts, credit analysis, and securities issuance. A financing decision is not judged solely by whether debt is cheaper than equity. Debt creates tax benefits but also fixed obligations, refinancing risk, covenant restrictions, and potential financial distress. Equity is more flexible but generally expensive and may dilute ownership. The appropriate financing mix therefore depends on business risk, taxation, asset quality, market conditions, agency relationships, and managerial objectives.

Learning Objectives

By the end of this chapter, the reader should be able to:

1. Estimate the cost of debt, preference shares, retained earnings, and ordinary equity.
2. Calculate and interpret the weighted average cost of capital (WACC).
3. Distinguish operating leverage from financial leverage and evaluate their combined effect.
4. Explain the net income, net operating income, traditional, Modigliani–Miller, trade-off, pecking-order, and agency perspectives on capital structure.
5. Assess debt capacity, credit quality, covenant headroom, and refinancing risk.
6. Recommend financing mixes while considering taxes, markets, agency costs, governance, and ethical constraints.

1. Foundational Concepts

1.1 Required return and opportunity cost

The cost of capital is an opportunity cost: the return that investors could reasonably earn on investments of comparable risk. It is not necessarily the coupon rate, accounting interest expense, or historical cost of funds. For a new project, the relevant rate is normally the required return on securities exposed to the project’s incremental risk.

A firm should use the marginal cost of capital for new financing when the financing decision concerns additional funds. The historical average cost may be informative for reporting but can be inappropriate for evaluating a new investment.

1.2 Market-value weights

WACC should generally use market values because market values represent current investor assessments of the claims. Book values may be used when market values are unavailable, but this should be disclosed and sensitivity-tested.

The principal financing categories are:

2. Estimating Component Costs

2.1 Cost of debt

For a perpetual debt instrument with annual interest payment I and market price P_d, the before-tax cost of debt is:

Here, k_d is the annual pre-tax cost of debt. This simple expression applies only when the debt is perpetual or when the price is being approximated without considering maturity and redemption value.

For a coupon bond with current market price P_d, annual coupon C, redemption value F, maturity of n years, and periodic yield r, the exact yield to maturity is the discount rate satisfying:

If coupons are paid semi-annually, C, r, and n must be expressed per half-year, with the resulting yield annualised consistently. Yield to maturity assumes that promised payments are made and that interim cash flows can be reinvested at the yield; it is not necessarily the issuer’s realized future borrowing cost.

When debt interest is tax-deductible, the after-tax cost is often estimated as:

T is the applicable marginal corporate tax rate. This formula assumes that the firm has sufficient taxable income to use the interest deduction, tax rules permit the deduction, and the tax shield is received at approximately the same time as the interest benefit. Interest limitation rules, loss carry-forwards, minimum taxes, and changing tax rates may make the effective benefit different.

Worked example. A company issues perpetual debt with an annual interest payment of $8 and a market price of $100. Its tax rate is 25%.

Before-tax cost:

k_d = 8 ÷ 100 = 8%

After-tax cost:

k_d(after tax) = 8% × (1 − 0.25) = 6%

The 6% estimate is valid only if the interest deduction is usable and the debt’s risk remains represented by the observed market price.

2.2 Cost of preference shares

For a perpetual preference share with annual dividend D_p and current market price P_p:

Preference dividends are normally not tax-deductible, so no corporate tax adjustment is made in the conventional calculation. If preference shares are redeemable, the required return should be estimated using an internal rate of return that incorporates dividends, issue price, redemption value, and maturity.

2.3 Cost of ordinary equity: dividend growth model

For a share with expected dividend next year D₁, current market price P₀, and constant expected dividend growth g, the Gordon growth model is:

The dividend yield and growth rate must be consistent with the same risk, currency, and time horizon. D₁ is the dividend expected one period from now, not the most recently paid dividend. If the latest dividend is D₀, then D₁ = D₀ × (1 + g).

The model assumes perpetual constant growth, a stable payout policy, and a required return greater than the growth rate. It is unsuitable for firms with no dividends, unstable growth, or materially changing leverage.

Example. If a share sells for $40, the expected dividend next year is $2.40, and expected perpetual growth is 4%:

k_e = 2.40 ÷ 40 + 0.04 = 10%

2.4 Cost of equity: security market line approach

The capital asset pricing model (CAPM) estimates the expected return required for systematic risk:

R_f is the risk-free rate, R_m is the expected market return, and β_e is the equity beta. The term R_m − R_f is the market risk premium. The model assumes investors are diversified, markets are sufficiently competitive, and beta captures relevant systematic risk. In practice, the choice of risk-free maturity, market index, beta period, and country risk premium can materially affect the estimate.

For an international or emerging-market valuation, analysts may add a country risk premium, but the approach must avoid double-counting risks already embedded in cash flows or beta. Private-company betas are often estimated by using comparable listed firms, removing their financial leverage, and relevering for the target capital structure.

A commonly used unlevering and relevering relationship is:

These expressions rely on simplifying assumptions about debt risk, tax deductibility, and the relationship between operating and financial risk. They should not be applied mechanically when debt is risky or tax shields are uncertain.

2.5 Flotation costs and retained earnings

Issuing new equity may involve underwriting fees, legal costs, registration expenses, and discounts. If flotation costs are represented by fraction f, the dividend-growth estimate for new shares is often adjusted as:

Retained earnings do not carry an invoice, but they have an opportunity cost: shareholders could have received the funds and invested them elsewhere at a comparable risk-adjusted return. Thus, retained earnings are generally assigned a cost close to the cost of existing equity, although flotation costs may not apply.

3. Weighted Average Cost of Capital

WACC combines component costs according to the market-value proportions of financing:

where w_d, w_p, and w_e are the market-value weights of debt, preference shares, and ordinary equity; k_d, k_p, and k_e are their pre-tax or relevant component costs. The weights must sum to one. Debt is tax-adjusted only when the tax shield is applicable.

For a single project, WACC is an appropriate discount rate only when the project has risk and leverage comparable to the existing firm and financing policy is stable. A project with materially different business risk should be valued using a project-specific cost of capital, often beginning with the asset beta of comparable firms.

Integrated example. A firm has the following market-value financing:

The corporate tax rate is 25%. Total capital is $100 million, giving weights of 0.30, 0.10, and 0.60.

The estimated WACC is therefore approximately 10.28%. This rate is an estimate, not a universal hurdle rate. Its validity depends on the risk and financing characteristics of the cash flows being discounted.

4. Operating, Financial, and Combined Leverage

Leverage describes the sensitivity of a firm’s results to changes in sales or operating income.

4.1 Operating leverage

Operating leverage arises from fixed operating costs such as salaried production staff, property costs, and depreciation. With constant selling price and unit variable cost, the degree of operating leverage at a particular sales level is:

Contribution equals sales minus variable operating costs, and EBIT is earnings before interest and tax. A high DOL means a small percentage change in sales produces a larger percentage change in EBIT. It also means greater exposure to demand risk.

The accounting break-even quantity is:

F is fixed operating cost, P is selling price per unit, and V is variable cost per unit. This formula excludes interest, taxes, and financing costs.

4.2 Financial leverage

Financial leverage arises from fixed financing charges. At a given operating level:

I is interest expense and D_p is preference dividend. The expression converts preference dividends to a pre-tax equivalent. If there are no preference dividends, DFL = EBIT ÷ (EBIT − I). High DFL magnifies changes in earnings available to ordinary shareholders, both positively and negatively.

4.3 Combined leverage

When operating and financial leverage interact:

DCL measures the approximate percentage change in earnings available to ordinary shareholders resulting from a 1% change in sales, around a specified operating point. These ratios are local measures; they can change significantly as sales move toward or away from break-even.

Example. Suppose sales are $10 million, variable costs are $6 million, fixed operating costs are $2 million, and interest is $0.5 million. Contribution is $4 million and EBIT is $2 million.

DOL = 4 ÷ 2 = 2.0

DFL = 2 ÷ (2 − 0.5) = 1.333

DCL = 2.0 × 1.333 ≈ 2.67

Approximately, a 10% change in sales would produce a 26.7% change in earnings available to ordinary shareholders, assuming prices, variable costs, fixed costs, interest, and tax conditions remain locally stable.

5. Capital Structure Theories

5.1 Net income and net operating income views

The net income approach argues that debt is cheaper than equity and that increasing debt can reduce WACC and increase firm value, at least within the model. It implicitly assumes that the cost of debt and equity do not rise sufficiently as leverage increases.

The net operating income approach argues that overall capitalization rate remains constant. Any cheaper debt benefit is exactly offset by an increase in the cost of equity caused by greater financial risk. Under this view, capital structure does not affect total firm value in perfect markets.

The traditional approach occupies an intermediate position. Moderate debt may reduce WACC because debt is relatively inexpensive, but beyond an optimal range, rising financial risk increases the costs of debt and equity. WACC is therefore U-shaped, and an optimal capital structure exists where WACC is minimized.

5.2 Modigliani–Miller propositions

Under the original Modigliani–Miller model without taxes, perfect and frictionless capital markets imply that firm value is independent of capital structure. Investors can create personal leverage, and financing rearranges claims without changing the operating cash flows of the firm.

With corporate taxes and deductible interest, debt creates a tax shield. In the simplest perpetual setting:

V_L is the value of a levered firm, V_U is the value of an otherwise identical unlevered firm, and D is the market value of permanent debt. The formula assumes a permanent, fully usable tax shield and abstracts from distress and other costs. It does not imply that firms should use unlimited debt in reality.

5.3 Trade-off theory

Trade-off theory balances the marginal tax benefit of debt against expected costs of financial distress and agency costs. Distress costs include legal and restructuring expenses, loss of customers and suppliers, employee departures, underinvestment, and forced asset sales. Expected distress cost can be represented conceptually as:

The optimum is reached where the marginal tax benefit of additional debt equals the marginal expected cost of distress and related frictions. Firms with stable cash flows, tangible collateral, and low business risk generally have greater debt capacity than firms with volatile earnings, intangible assets, or rapid growth opportunities.

5.4 Pecking-order theory

Pecking-order theory emphasizes information asymmetry. Managers typically know more about firm prospects than outside investors. Issuing equity may signal that managers believe shares are overvalued, while borrowing can signal confidence but increases contractual risk. Firms therefore tend to prefer:

1. Internal funds;
2. Safe debt;
3. Riskier debt or hybrid securities;
4. New equity as a last resort.

The theory does not predict a single optimal debt ratio. Financing deficits, investment opportunities, and accumulated internal funds may explain observed leverage.

5.5 Agency theory

Debt can reduce agency problems between managers and shareholders by imposing discipline through mandatory payments and monitoring. However, debt also creates conflicts between shareholders and creditors. Shareholders may have incentives to undertake excessively risky projects, reject positive projects that primarily benefit creditors, or extract value through distributions. Covenants, collateral, pricing, board oversight, and lender monitoring are mechanisms for controlling these conflicts.

5.6 Market timing and lifecycle perspectives

Market-timing theory suggests that firms issue equity when market valuations appear high and repurchase or issue debt when equity appears undervalued. Lifecycle theory predicts that young firms with intangible growth opportunities rely more on equity, while mature firms with predictable cash flows can support more debt and return capital to shareholders.

No single theory explains every financing decision. In practice, executives combine tax, distress, information, agency, control, market-timing, and strategic considerations.

6. Assessing Credit Capacity

Credit capacity is the amount of debt a firm can carry while maintaining acceptable default risk, strategic flexibility, and access to funding. It is not determined by a single ratio.

6.1 Core credit metrics

A ratio should be interpreted relative to industry, business cycle, accounting policies, covenant definitions, and the stability of cash flows. EBITDA is not cash flow: it ignores taxes, working capital, maintenance capital expenditure, and other cash requirements.

6.2 A structured credit assessment

A professional assessment should examine:

• Business risk: industry cyclicality, competitive position, customer concentration, regulation, and technological disruption.
• Operating risk: fixed-cost intensity, margin volatility, and sensitivity to volumes and prices.
• Asset quality: collateral value, liquidity, obsolescence, and recoverability.
• Cash-flow capacity: recurring free cash flow under base, downside, and severe but plausible scenarios.
• Refinancing risk: maturity concentration, floating-rate exposure, currency mismatch, and dependence on market access.
• Covenants: leverage limits, interest coverage, restricted payments, liens, acquisitions, and change-of-control provisions.
• Governance: financial reporting quality, related-party transactions, risk controls, and managerial incentives.

Stress testing should model lower revenue, margin compression, higher interest rates, delayed receivables, currency depreciation, and restricted refinancing. The firm should evaluate not only the probability of covenant breach but also the consequences of losing flexibility before legal default occurs.

7. Financing Mix under Constraints

A financing recommendation should begin with the purpose and duration of funding. Long-lived assets should generally be financed with stable, appropriately matched capital. Working-capital needs may use revolving facilities, while acquisitions may require bridge finance followed by permanent debt or equity.

The recommendation should consider:

1. Risk capacity: How much volatility can the firm withstand?
2. Debt capacity: What leverage is sustainable under downside conditions?
3. Cost: What is the marginal after-tax cost, including fees and embedded options?
4. Flexibility: Can the firm fund growth, acquisitions, or shocks without distressed issuance?
5. Control: Will equity issuance dilute voting power or strategic control?
6. Market access: Are debt and equity markets open and liquid?
7. Tax and regulation: Are interest deductions limited? Do prudential or sector rules constrain leverage?
8. Stakeholder effects: Could leverage harm employees, suppliers, customers, or financial stability?

A financing mix should be evaluated using scenario analysis rather than a single WACC. Analysts should prepare base, downside, and severe scenarios, calculate coverage and covenant headroom, and identify trigger points for corrective action.

8. Illustrative Case: Meridian Components Ltd.

Background

Meridian Components Ltd. is an illustrative mid-sized manufacturer supplying automobile and industrial-equipment producers. It plans a $50 million capacity expansion. Existing financing is $30 million of debt and $70 million of equity at market value. The firm’s pre-expansion debt carries a 7% rate, the estimated cost of equity is 12%, and the corporate tax rate is 25%. Management is considering financing the expansion entirely with debt, entirely with equity, or with a balanced mix.

Problem

The board wants the lowest financing cost but also requires that interest coverage remain above 4.0 times in the downside case. Current EBITDA is $24 million, EBIT is $18 million, and existing annual interest is $2.1 million. The expansion is expected to add $6 million of EBITDA and $3 million of depreciation at full operation, but demand could be 30% below plan in the first two years.

Analysis

Existing market-value weights are 30% debt and 70% equity. The current WACC is:

If the expansion is financed entirely by debt at 8%, total debt becomes $80 million and annual interest becomes $6.1 million. At full operation, projected EBIT is 18 + (6 − 3) = 21 million, producing interest coverage of approximately 21 ÷ 6.1 = 3.44 times. This fails the board’s stated threshold even before considering downside performance.

If financed entirely by equity, interest remains $2.1 million. Full-operation interest coverage is approximately 21 ÷ 2.1 = 10.0 times, but existing shareholders experience dilution and the issue may be expensive if market conditions are weak.

Consider a 40% debt and 60% equity financing mix for the expansion. New debt is $20 million at 8%, adding $1.6 million interest. Total interest is $3.7 million. At full operation, interest coverage is 21 ÷ 3.7 ≈ 5.68 times. Under a simplified downside assumption that the incremental EBITDA and depreciation are both 30% lower, incremental EBIT is (6 × 0.70) − (3 × 0.70) = 2.1 million. Total downside EBIT is $20.1 million, and coverage is 20.1 ÷ 3.7 ≈ 5.43 times. This provides more resilience than the all-debt option.

The 40/60 mix should not be accepted solely because it satisfies one ratio. The board should also examine cash taxes, working capital, capital expenditure, covenant definitions, floating-rate exposure, debt maturities, and the possibility that the expansion requires additional funds.

Approach and recommendation

Meridian should use a balanced mix, potentially supplemented by a committed revolving facility. A proposed structure could include $20 million of long-term debt, $30 million of equity or retained earnings, and a liquidity facility for construction and working-capital volatility. The debt should be matched to the economic life of the expansion, with fixed-rate or hedged exposure where appropriate. Covenants should preserve operating flexibility while providing early-warning information.

Outcome and learning points

The illustrative analysis shows why the cheapest apparent source is not necessarily the best financing source. All-debt financing may produce a lower initial WACC but can breach the firm’s risk tolerance. A balanced structure preserves credit access, reduces distress risk, and limits dilution. The final decision should be based on risk-adjusted value, not on a mechanically minimized WACC.

9. Limitations, Governance, and Ethical Issues

Cost-of-capital estimates contain model risk. Betas are backward-looking and unstable; market risk premiums are judgmental; dividend growth may be unrealistic; and credit spreads change rapidly. WACC can be misused when a firm applies one rate to projects with different risks. Analysts should disclose assumptions, use ranges, and perform sensitivity analysis.

Financing decisions also raise governance concerns. Managers may prefer debt to avoid dilution even when leverage threatens creditors and employees. Investment banks must manage conflicts involving underwriting, advisory mandates, research, and distribution. Issuers must provide fair, complete, and non-misleading disclosure of leverage, covenants, use of proceeds, and downside risks. Manipulating EBITDA definitions or temporarily shifting liabilities to improve covenant ratios undermines market integrity.

Regulatory constraints may be especially important for banks and other financial institutions. Prudential capital, liquidity, large-exposure, resolution, and stress-testing requirements mean that accounting leverage alone cannot describe risk. For banks, regulatory capital composition and risk-weighted assets may be more relevant than a conventional corporate debt-to-equity ratio.

10. Technology and Contemporary Practice

Modern investment-banking teams use data platforms to monitor yield curves, credit spreads, covenant compliance, peer leverage, and market liquidity. Automated models can run thousands of scenarios and identify refinancing concentrations. Machine-learning tools may assist in predicting default or estimating spreads, but their outputs can reflect biased, incomplete, or non-stationary data. Explainability, model validation, cybersecurity, data governance, and human review remain essential.

Contemporary financing practice increasingly incorporates sustainability-linked pricing, transition finance, private credit, asset-based lending, and hybrid securities. These instruments can broaden funding sources but may introduce complex triggers, reporting requirements, liquidity constraints, and reputational risks. Sustainability claims should be supported by measurable targets and credible verification rather than used as a substitute for sound credit analysis.

Best-Practice Decision Framework

A disciplined financing process should:

1. Forecast operating and free cash flows under multiple scenarios.
2. Estimate component costs using market-consistent inputs.
3. Use market-value weights and project-specific risk where appropriate.
4. Measure leverage, coverage, liquidity, maturity, currency, and rate risks.
5. Quantify tax benefits but recognize interest limitations and uncertain utilization.
6. Evaluate distress, agency, control, and information costs.
7. Test covenant headroom under severe but plausible conditions.
8. Match debt maturity and amortization to asset cash flows.
9. Preserve sufficient liquidity and refinancing flexibility.
10. Document assumptions, conflicts, governance controls, and monitoring triggers.

Chapter Summary

Cost of capital is the risk-adjusted opportunity cost demanded by providers of finance. Debt cost is estimated from market yields or cash-flow pricing and may be reduced by an effective interest tax shield. Preference-share cost is based on dividends and price, while equity cost may be estimated using dividend growth or CAPM, subject to their assumptions and limitations. WACC combines relevant component costs using market-value weights and is appropriate only when project risk is comparable to the financing base.

Operating leverage reflects fixed operating costs; financial leverage reflects fixed financing commitments; and combined leverage shows how sales volatility can magnify shareholder earnings volatility. Capital structure theories provide different explanations: perfect-market irrelevance, tax-shield benefits, trade-offs with distress costs, financing hierarchies under information asymmetry, agency controls, market timing, and lifecycle effects. Credit capacity must be assessed through cash-flow resilience, coverage, collateral, covenants, liquidity, maturity structure, and governance. A sound financing recommendation balances cost with solvency, flexibility, control, regulation, and stakeholder responsibility.

Key Terms

Cost of capital: Required return demanded by providers of finance.

Opportunity cost: Return forgone by investing funds in one use rather than the next-best comparable-risk use.

Cost of debt: Required return on borrowing before or after applicable tax effects.

Cost of equity: Required return of ordinary shareholders.

WACC: Weighted average of relevant financing costs using capital weights.

Market-value weights: Financing proportions based on current market values.

Capital structure: Mix of debt, equity, preference shares, and other financing claims.

Operating leverage: Sensitivity of EBIT to changes in sales caused by fixed operating costs.

Financial leverage: Sensitivity of shareholder earnings to EBIT caused by fixed financing charges.

Combined leverage: Joint effect of operating and financial leverage.

EBIT: Earnings before interest and tax.

EBITDA: Earnings before interest, tax, depreciation, and amortisation.

CAPM: Model linking expected return to the risk-free rate and systematic risk.

Beta: Sensitivity of an asset’s return to market movements.

Tax shield: Reduction in tax attributable to deductible financing costs.

Financial distress: Economic and contractual costs associated with difficulty meeting obligations.

Debt capacity: Sustainable amount of borrowing consistent with risk tolerance and cash flow.

Covenant: Contractual restriction or performance condition in a financing agreement.

Pecking-order theory: View that firms prefer internal funds, then debt, and equity last.

Agency cost: Cost arising from conflicts among managers, shareholders, and creditors.

Review Questions

5 Short Answer Questions

1. Why is the market-value cost of debt generally preferred to the historical interest rate?
2. State the assumptions underlying the constant-growth dividend model.
3. What is the difference between operating leverage and financial leverage?
4. Why are retained earnings assigned an opportunity cost?
5. Identify two factors that can reduce a firm’s debt capacity.

5 Long Answer Questions

1. Explain how the component costs of debt, preference shares, and ordinary equity are estimated, including key limitations.
2. Derive and interpret the WACC framework and discuss when it should not be used as a project discount rate.
3. Compare the trade-off, pecking-order, agency, and market-timing theories of capital structure.
4. Explain how operating, financial, and combined leverage affect risk and shareholder returns.
5. Discuss how an investment bank should assess a borrower’s credit capacity before arranging debt finance.

3 Analytical / Application Questions

1. A company has market-value debt of $40 million at a pre-tax cost of 8%, equity of $60 million at a cost of 14%, and a 25% tax rate. Calculate WACC and explain two reasons why the result may not be an appropriate rate for a high-risk new project.
2. A firm has sales of $15 million, variable costs of $9 million, fixed operating costs of $3 million, and interest of $0.75 million. Calculate DOL, DFL, and DCL, and interpret the effect of a 5% sales decline.
3. Design a financing recommendation for a cyclical manufacturer whose assets are tangible but whose cash flows are volatile. Address debt proportion, maturity, covenants, liquidity, interest-rate exposure, and downside stress testing.

Multiple Choice Questions with Answers

Question 1

A company’s perpetual debt pays annual interest of $6 and has a market price of $75. What is its approximate before-tax cost of debt?

A. 6.0%

B. 8.0%

C. 12.5%

D. 13.3%

Correct Answer: B. 8.0%

Question 2

Which input is normally preferred when calculating capital-structure weights for WACC?

A. Historical book value of debt

B. Original issue value of equity

C. Current market value of financing claims

D. Nominal value of authorised shares

Correct Answer: C. Current market value of financing claims

Question 3

A firm has a pre-tax cost of debt of 8% and a corporate tax rate of 25%, assuming the interest tax shield is fully usable. What is the after-tax cost of debt?

A. 2%

B. 6%

C. 8%

D. 10.67%

Correct Answer: B. 6%

Question 4

Under the constant-growth dividend model, the cost of equity equals:

A. Dividend yield minus growth

B. Risk-free rate plus beta only

C. Expected dividend yield plus expected growth

D. Interest expense divided by debt

Correct Answer: C. Expected dividend yield plus expected growth

Question 5

Sales are $10 million, variable costs are $6 million, and EBIT is $2 million. What is the degree of operating leverage?

A. 0.5

B. 1.5

C. 2.0

D. 4.0

Correct Answer: C. 2.0

Question 6

If EBIT is $2 million and interest expense is $0.5 million, with no preference dividends, the degree of financial leverage is approximately:

A. 0.75

B. 1.33

C. 2.50

D. 4.00

Correct Answer: B. 1.33

Question 7

Which theory emphasizes the preference for internal funds, followed by debt, with new equity generally last?

A. Pecking-order theory

B. Net operating income theory

C. Pure irrelevance theory

D. Agency-free theory

Correct Answer: A. Pecking-order theory

Question 8

Under the simplest Modigliani–Miller model with corporate taxes, the value contribution of permanent debt is represented by:

A. The expected distress cost

B. The interest tax shield

C. The equity flotation cost

D. The operating break-even point

Correct Answer: B. The interest tax shield

Question 9

Which measure directly assesses the ability to pay interest from EBIT?

A. Debt-to-equity ratio

B. Interest coverage ratio

C. Dividend payout ratio

D. Inventory turnover

Correct Answer: B. Interest coverage ratio

Question 10

Why may an all-debt financing plan be rejected even if debt has the lowest component cost?

A. Debt never creates tax benefits

B. Debt always increases share price

C. Fixed obligations can create distress and covenant risk

D. Equity has contractual priority over debt

Correct Answer: C. Fixed obligations can create distress and covenant risk