Capital structure
By SuperdayReps · Michigan Ross Undergrad | Wharton MBA · ex-Citi | ex-Greenhill · Former Head Mentor at a Leading IB Prep Service
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.
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Frequently asked
- What is capital structure?
- Capital structure is the mix of debt and equity a company uses to fund itself. Debt is borrowed money that must be repaid with interest and sits senior in line, while equity is money from owners who get whatever is left over. The blend a company chooses changes its value, its risk, and the return owners can earn.
- Why is debt cheaper than equity?
- Debt is cheaper for two reasons. First, interest is tax-deductible, so the government subsidizes part of the cost through the tax shield. Second, lenders are senior and get paid before owners, so they take less risk and demand a lower return. Equity holders sit last in line and demand the highest return.
- How does adding debt affect WACC?
- Adding debt lowers WACC at first because debt is the cheaper ingredient and the tax shield pulls the blended rate down further. But past some point, more debt raises distress risk, so both lenders and shareholders demand more, and WACC turns back up. The optimal capital structure sits in that middle zone.
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