Every company needs funding to operate and grow. Some raise money by issuing shares. Others borrow through loans or bonds. Most do a bit of both. The way a company balances these sources of funding is called its capital structure—and it has a direct impact on both valuation and financial risk.
But how much debt is too much? When does equity become too expensive? And is there really such a thing as the “optimal” capital structure?
In this article, we’ll break down what capital structure means, how debt and equity differ, what trade-offs companies face when choosing between them, and how the concept of an “optimal” capital structure fits into valuation and financial strategy.
What Is Capital Structure?
Capital structure refers to the mix of debt and equity a company uses to finance its operations and investments.
- Equity is ownership capital—usually in the form of common shares, sometimes preferred shares. Shareholders expect upside in the form of dividends and capital gains.
- Debt is borrowed capital—loans, bonds, credit lines. Lenders expect fixed interest payments and principal repayment, not ownership.
Together, these two sources form the company’s total capital base. The capital structure determines who gets paid first, how risk is shared, and how returns are distributed.
A company that’s 100% equity-financed has no leverage. One that’s 70% debt and 30% equity is highly levered—and potentially more risky, but also more tax-efficient.
Capital structure isn’t just a balance sheet item. It affects valuation through the cost of capital, the volatility of earnings, and even strategic flexibility.
The Trade-Offs Between Debt and Equity
There’s no one-size-fits-all capital structure. The choice between debt and equity involves a series of trade-offs—each with real consequences for risk, cost, and control.
Debt: Cheaper but Riskier
Debt is often less expensive than equity. Interest payments are usually tax-deductible, and lenders don’t demand a share of the company’s future upside. For this reason, moderate levels of debt can lower the company’s WACC, increasing valuation.
But debt comes with fixed obligations. Miss an interest payment, and the consequences are immediate. Too much debt increases financial risk, credit rating pressure, and bankruptcy risk—especially in downturns or volatile industries.
Equity: Safer but Dilutive
Equity doesn’t need to be repaid, and there are no required dividends. That makes it a safer choice—especially for companies with unstable cash flows or uncertain business models.
The downside is that equity is usually more expensive than debt. Investors expect higher returns because they take on more risk—and issuing new shares dilutes ownership. That’s why companies try to avoid raising equity unless they have to (e.g. early-stage growth or post-crisis restructuring).
The core trade-off:
- Debt lowers cost of capital, but increases financial risk.
- Equity lowers financial risk, but raises cost of capital.
A company’s goal is to strike a balance between the two—enough debt to benefit from leverage, but not so much that it becomes dangerous.
What Is the Optimal Capital Structure?
The optimal capital structure is the mix of debt and equity that minimizes the company’s overall cost of capital (WACC) and maximizes its value. In theory, there’s a point where the benefit of taking on more debt (mainly the tax shield) is exactly balanced by the increased financial risk it brings.
That’s the sweet spot: not too much debt, not too little—just enough to enhance returns without destabilizing the company.
Theoretical Foundations: Modigliani & Miller
Economists Franco Modigliani and Merton Miller introduced the original theory in the 1950s. They argued that in a perfect market (no taxes, no bankruptcy risk), capital structure doesn’t affect a company’s value. But in the real world—where taxes, distress costs, and imperfect markets exist—capital structure does matter.
Their later models introduced two key ideas:
- Tax Shield – Interest on debt is tax-deductible, so more debt lowers taxes and increases firm value.
- Bankruptcy Cost – As debt increases, so does the risk of default. Eventually, these costs offset the tax benefits.
The balance between these two is what defines the optimal capital structure.
In Practice: It Depends
There’s no universal “ideal” debt-to-equity ratio. What’s optimal depends on:
- Industry norms (utilities can support more debt than tech startups)
- Cash flow stability (predictable businesses can take on more leverage)
- Access to capital markets (large firms can refinance more easily)
- Management’s risk appetite and strategic goals
- Macroeconomic conditions (interest rates, credit cycles, tax policy)
In investment banking, we often benchmark against peer company averages, run sensitivity scenarios, and consider what level of leverage supports the strategic objectives without putting the business at risk.
Closing Thoughts
Capital structure is more than just a financing decision—it’s a strategic choice that influences risk, valuation, and long-term flexibility. The optimal mix of debt and equity isn’t fixed. It depends on the company’s business model, its industry, its growth plans, and its ability to weather downturns.
Too little debt can leave value on the table. Too much can magnify losses and limit optionality. The goal is to find the balance point—where financing costs are minimized, but risk remains manageable.
In valuation, capital structure feeds directly into WACC, which in turn drives DCF outcomes and deal pricing. That’s why understanding how debt and equity interact is essential—not just for corporate finance theory, but for real-world decisions across M&A, private equity, and capital markets.