Capital Structure & Leverage: How Companies Are Built

If you wanted to buy a house worth ₹50 Lakhs, but you only had ₹10 Lakhs in your pocket, what would you do? You would take a bank loan for the remaining ₹40 Lakhs.

Congratulations! You just created a Capital Structure . In business terms, your house is financed by 20% Equity (your money) and 80% Debt (bank loan). Every company in the world faces this same decision every day: "To grow, should we use our own money or borrow someone else's?"

The Golden Balance: Too much debt is dangerous (you might go bankrupt). Too much equity is expensive (you share profits). The magic lies in finding the perfect mix.

1. What is Capital Structure?

Capital Structure is simply the recipe a company uses to cook up its funds. Just like a cake needs a specific mix of flour and sugar, a company needs a mix of:

• 1. Debt (Loans/Bonds)

  Borrowed money. You must pay interest regardless of profit. It's risky but "cheap" because interest is tax-deductible.

• 2. Equity (Shares/Stocks)

  Owner's money. You don't have to pay interest, but you give away ownership and future profits. It's safe but "expensive".

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2. Financial Leverage: The Magnifying Glass

Why do companies borrow money if they have to pay it back? The answer is Leverage .

Think of a physical lever. With a lever, you can lift a heavy rock with little effort. In finance, using Debt acts as a lever. It allows you to buy bigger assets and make bigger profits with a small amount of your own money.

3. The Modigliani-Miller (MM) Theorem: The Pizza Analogy

Two Nobel Prize winners, Franco Modigliani and Merton Miller, came up with a famous theory. They asked: Does the value of a company change if we change its Debt/Equity mix?

Their Answer (Simplified): No. (In a perfect world).

The Pizza Analogy: Imagine a pizza represents a company. The size of the pizza is the company's value.

• If you cut the pizza into 4 slices (All Equity), is it bigger? No.
• If you cut it into 8 slices (Debt + Equity), is it bigger? No.

MM Theorem says that how you slice the company (capital structure) doesn't change the size of the pie (company value) . The value depends on the quality of the business (the taste of the pizza), not how you pay for it.

*Note: This is only true in a theoretical world without taxes or bankruptcy costs. In the real world, taxes exist, so debt actually creates value due to tax savings!

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4. Finding the "Sweet Spot" (Optimal Structure)

So, how much debt is too much? Companies try to find the Optimal Capital Structure . This is the point where their WACC (Cost of Capital) is the lowest, and their Market Value is the highest.

5. Real World Examples

• Apple & Google: They have billions in cash but still issue bonds (borrow money). Why? Because debt is "cheap" (low interest) and saves them tax. They use leverage to boost returns for shareholders.
• Real Estate Companies: They use massive amounts of debt (High Leverage) because their assets (land/buildings) are stable and can be used as collateral.
• Tech Startups: They use almost zero debt (All Equity) because their future is uncertain, and they can't afford fixed monthly interest payments.