Capital structure
6 min read · updated July 8, 2026
Every company funds itself with some blend of two things: money it borrows and money its owners put in. That blend is its capital structure, and the two ingredients are debt and equity. Debt is borrowed money you must pay back with interest. Equity is money from owners who get whatever is left over. How you split the funding between the two changes what the business is worth, how risky it is, and how much return the owners can earn.
Debt is cheaper than equity
This surprises people at first, but debt is the cheaper way to fund a company, for two reasons.
First, interest is tax-deductible. When a company pays interest to lenders, that interest comes off its taxable income, so the government effectively subsidizes part of the cost. This saving is the tax shield. If a company borrows at a 5% interest rate and pays a 20% tax rate, the true cost after the tax saving is only 4%, because every dollar of interest cuts its tax bill. That after-tax number is the cost of debt that matters.
Second, lenders take less risk than owners, so they demand less return. Debt is senior, meaning lenders get paid first, before owners see a cent. The safest layer, senior debt, sits right at the front of the line and is often backed by the company's assets. Because a lender is more likely to get their money back, they accept a lower return for it.
Equity is expensive but forgiving
Equity does the opposite on every count. Shareholders sit last in line, they only get paid after every lender is made whole, so they carry the most risk and demand the highest return. That is the cost of equity, and it is always higher than the cost of debt.
But equity has one enormous advantage: it has no mandatory payments. A company never has to pay a dividend. If business is bad this year, it can simply not pay owners, and nothing breaks. Equity absorbs the downside. Debt does not offer that mercy. Interest and principal are due on a fixed schedule whether the company had a great year or a terrible one, and missing those payments can push it into default and bankruptcy.
Debt is cheaper but rigid. Equity is expensive but flexible. Adding debt lowers your cost of funding but loads the company with fixed payments it must make in good times and bad. That single tension, cheap-and-risky against expensive-and-safe, is the whole reason capital structure is a decision at all.
The effect on WACC
Blend the cost of debt and the cost of equity together, weighted by how much of each the company uses, and you get its WACC, the overall rate it pays to fund itself. Because debt is the cheaper ingredient, mixing some in pulls the blended rate down. The tax shield pulls it down further.
Say a firm's cost of equity is 10% and its after-tax cost of debt is 4%. Watch what happens to WACC as it swaps in some cheap debt:
| Debt share of funding | After-tax cost of debt | Cost of equity | WACC |
|---|---|---|---|
| 0% | n/a | 10% | 10.0% |
| 40% | 4% | 10% | 7.6% |
Moving from all-equity to 40% debt drops the blended cost from 10% to 7.6%. A lower WACC means a higher valuation, so a bit of leverage genuinely helps.
But this does not continue forever. Past some point, piling on more debt makes both lenders and shareholders nervous. The odds of financial distress climb, lenders charge higher interest to keep lending, and shareholders demand more return for the extra risk. Both costs rise, and WACC turns back up. Somewhere in the middle sits a rough "optimal" capital structure: enough debt to capture the cheap funding and the tax shield, not so much that distress risk swamps the benefit. A common way to track how far you have pushed it is the leverage ratio, debt divided by EBITDA.
Why buyouts load up on debt
This is exactly why a private equity firm deliberately funds an LBO with a lot of debt. Leverage amplifies the return on the owners' equity. The sponsor writes a small equity check, borrows the rest, and lets the company's own cash flow pay the debt down over time.
Here is the amplifier in clean numbers. A business worth $1,000 today is sold for $1,500 in five years. Buy it with all equity and you turn $1,000 into $1,500, a 1.5x return. Now buy the same business with $600 of debt and $400 of equity. Over the hold, cash flow pays the debt down to $300, so at sale your equity value is $1,500 minus $300, or $1,200. You turned $400 into $1,200, a 3.0x return on the identical business. The lenders took fixed interest and their principal back, and everything above that landed on your thin equity slice.
Assuming more debt is always better because it lifts returns. Leverage cuts both ways. If that same business is worth only $800 at exit, the all-equity buyer is down a little, but the levered buyer, still owing $300, is nearly wiped out. Debt magnifies losses exactly as hard as it magnifies gains, which is why sponsors chase stable, predictable businesses that can carry the fixed payments safely.
For the return math itself, see What drives LBO returns, and for the blended-rate mechanics, see WACC explained.
If asked why debt is cheaper than equity, give both reasons, not one: interest is tax-deductible (the tax shield), and debt is senior and less risky so lenders demand a lower return. Then close the loop: cheap debt lowers WACC up to a point, after which rising distress risk pushes it back up. Naming the tax shield and the "optimal capital structure" reversal in the same breath is what separates a real answer from a memorized one.
Glossary
New to the lingo? Every term used above, in plain English.
- Capital structure
- The mix of debt and equity a company uses to fund itself. More debt is cheaper but riskier, and finding the right balance affects both value and risk.
- Cost of debt
- The rate a company pays to borrow. Because interest is tax-deductible, the after-tax cost of debt is what goes into WACC, and it is cheaper than equity.
- Cost of equity
- The return shareholders require to own a company stock, given its risk. Usually estimated with CAPM, and it is always higher than the cost of debt.
- Tax shield
- The tax a company saves because an expense is deductible. Depreciation, for example, lowers taxable income, so it saves cash on taxes even though it is non-cash.
- WACC (Weighted Average Cost of Capital)
- The blended rate a company pays to fund itself with both debt and equity. In a DCF it is the discount rate used to bring future cash back to today.
- Leverage ratio
- How much debt a company carries relative to its earnings, usually measured as debt divided by EBITDA. Higher leverage means more risk and more required debt paydown.
- Senior debt
- The safest, cheapest layer of borrowing, first in line to be repaid and usually secured by assets. It sits at the top of the capital structure.
- LBO (Leveraged Buyout)
- Buying a company using mostly borrowed money, then using the company’s own cash flow to pay that debt down over time. The classic private equity playbook.
- Sponsor
- A private equity firm. In an LBO the sponsor is the buyer that puts up the equity and controls the company.
- Private equity (PE)
- Firms that raise money to buy whole companies, improve them over several years, and sell them for a profit. They often use large amounts of borrowed money to do it.
- EBITDA
- Earnings Before Interest, Taxes, Depreciation, and Amortization. A rough proxy for a company’s operating cash profit, before financing and accounting choices.
- Equity Value
- The slice of a company that belongs to its shareholders. For a public company this is the market capitalization (share price times shares outstanding).
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