Glossary: M06 — Capital Structure

Term	Definition
Capital structure	Mix of debt and equity used to finance a company
Cost of capital	Rate of return required by capital suppliers
WACC	Weighted Average Cost of Capital
Cost of debt	Rate of return required by lenders (before or after tax)
Cost of equity	Rate of return required by shareholders
Tax shield	Reduction in taxes from deducting interest expense ( $r_{d} \times t$ )
Target capital structure	Management’s chosen (or targeted) proportions of debt and equity
CAPM	Capital Asset Pricing Model — $r_{e} = R_{F} + β [E (R_{M}) - R_{F}]$
Beta	Sensitivity of stock returns to market returns
Market risk premium	$E (R_{M}) - R_{F}$ — expected excess return of the market
BYPRP	Bond Yield Plus Risk Premium — $r_{e} = r_{d} + premium$
YTM approach	Estimating cost of debt using yield to maturity of the bond
Debt-rating approach	Estimating cost of debt using yields on comparably rated bonds
Modigliani-Miller	Propositions about the relevance of capital structure
Static trade-off theory	Optimal leverage balances tax shield vs. financial distress costs
Pecking order theory	Firms prefer internal funds > debt > equity (information asymmetry)
Financial distress	Difficulty meeting debt obligations; may lead to bankruptcy
Optimal capital structure	Leverage ratio that minimizes WACC and maximizes firm value

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