CFA Capital Structure Notes: WACC, Modigliani-Miller and Optimal Structure [Level 1]

What CFA capital structure notes cover

These CFA capital structure notes explain how a company chooses the mix of debt and equity that funds its assets, and how that mix sets the weighted-average cost of capital. The Modigliani-Miller propositions, the trade-off theory, and the pecking order theory then guide the search for an optimal structure. Capital structure matters because the blend of debt and equity changes the cost of capital, and the cost of capital drives firm value.

A lower cost of capital raises value, while a higher cost of capital lowers it. As a result, that link is why CFA Institute tests this topic at Level 1.

Capital structure is the mix of debt and equity that funds a company. The weighted-average cost of capital blends the after-tax cost of debt with the cost of equity. With taxes, debt adds value through the interest tax shield, and the structure balances that benefit against the cost of distress.

Corporate Issuers carries a weight of 6 to 9 percent in the 2026 CFA Level 1 exam, according to CFA Institute. The exam has 180 multiple-choice questions in two 135-minute sessions. In other words, that weight equals roughly 11 to 16 questions.

The November 2026 Level 1 window runs from 11 to 17 November 2026, and the next window runs from 22 to 28 February 2027. From February 2027, the 2027 curriculum applies and Corporate Issuers is renamed Corporate Finance, with the same 6 to 9 percent weight. See the free CFA notes hub and the companion overview of Corporate Issuers.

CFA Institute sets four learning outcomes for this module: calculate and interpret the WACC, explain the factors that affect capital structure and the WACC, explain the Modigliani-Miller propositions, and describe optimal and target capital structures.

CFA capital structure notes: the weighted-average cost of capital

The weighted-average cost of capital, or WACC, is the average return a company must pay to all of its capital providers, weighted by the market value of each source of funds. It blends the after-tax cost of debt with the cost of equity. As a result, WACC is the discount rate for new projects and the hurdle rate for value creation: a project adds value only when its return clears the WACC.

The formula is WACC = wd x rd x (1 – t) + we x re, where wd and we are the market value weights of debt and equity, rd is the pre-tax cost of debt, t is the marginal tax rate, and re is the cost of equity. Here, the (1 – t) term is the tax shield, because interest is tax deductible.

Worked example: WACC

For example, a company has debt of $400 million and equity of $600 million at market value. Pre-tax cost of debt is 6 percent, the tax rate is 25 percent, and the cost of equity is 12 percent.

• Step 1, weights. Total capital = $1,000m. Weight of debt = 40 percent. The equity weight is 60 percent.
• Step 2, after-tax cost of debt. After-tax cost of debt = 6% x (1 – 0.25) = 4.5%.
• Step 3, WACC. WACC = (0.40 x 4.5%) + (0.60 x 12%) = 9.0%.

The WACC is 9.0 percent, so new projects must earn more than 9.0 percent to add value. Notice how the tax shield pulls the WACC down: without tax, the same mix would give 9.6 percent.

A higher tax rate favors debt. Similarly, higher interest rates raise the cost of debt, and higher business risk raises the cost of equity.

Modigliani-Miller propositions

Modigliani and Miller assumed perfect capital markets, no taxes, no costs of financial distress, no transaction costs, and identical borrowing terms for firms and investors. The exam tests these assumptions, because every result depends on them.

First, Proposition I without taxes states that the value of a firm does not depend on its capital structure. A levered firm and an unlevered firm with the same assets have the same value, because investors can create homemade leverage by borrowing on their own account.

Second, Proposition II without taxes states that the cost of equity rises with leverage: re = r0 + (r0 – rd) x (D/E), where r0 is the cost of capital for an all-equity firm, rd is the cost of debt, and D/E is the debt-to-equity ratio.

Modigliani-Miller with taxes

Taxes change the answer. Interest is tax deductible, so debt creates a tax shield worth t x D, where t is the tax rate and D is the market value of debt. Proposition I with taxes then reads VL = VU + t x D. For Proposition II with taxes, re = r0 + (r0 – rd) x (D/E) x (1 – t). The (1 – t) term softens the rise.

Worked example: Modigliani-Miller with taxes

Consider an unlevered firm worth $100 million. It issues $40 million of debt, the tax rate is 30 percent, the cost of capital for an all-equity firm is 10 percent, and the cost of debt is 5 percent.

• Step 1, Proposition I with taxes. VL = VU + t x D = $100m + (0.30 x $40m) = $100m + $12m = $112m. The firm gains $12 million from the tax shield.
• Step 2, Proposition II with taxes. Equity is $112m minus $40m, or $72m, so D/E = 40 / 72. Then re = 10% + (10% – 5%) x (40 / 72) x (1 – 0.30) = 11.9%. The cost of equity rises from 10 percent to 11.9 percent.

The tax result tempts firms toward 100 percent debt, but the model ignores the cost of financial distress.

Trade-off theory and pecking order theory

The trade-off theory says a firm should add debt until the marginal benefit of the tax shield equals the marginal cost of financial distress. At that point, the WACC is at its lowest and firm value is at its highest. Below that point, more debt adds value.

The pecking order theory says firms prefer internal funds first, then debt, and equity only as a last resort. This order reflects information asymmetry: managers know more than outside investors, so issuing equity signals that the shares may be overvalued, and the market marks the price down. Debt sends a weaker signal, and retained earnings send none at all. Unlike the trade-off theory, it has no single optimal debt ratio.

CFA capital structure notes: optimal and target capital structure

The optimal capital structure is the mix of debt and equity that minimizes the WACC and maximizes firm value. It is a single point in theory, but firms aim at a target capital structure instead: a range of debt ratios they move toward over time, while keeping room to act when markets shift. A firm below its target may borrow, and a firm above its target may repay debt.

Learn the definition word for word: the mix that minimizes the WACC. The trade-off theory predicts a target ratio, and the pecking order theory does not.

Measures of leverage: DOL, DFL and DTL

Leverage measures how a change in sales flows through to profit. First, DOL equals the percent change in operating income divided by the percent change in sales. Next, DFL equals the percent change in earnings per share divided by the percent change in operating income. DTL equals the percent change in earnings per share divided by the percent change in sales, and it also equals DOL x DFL.

Worked example: leverage. Sales rise 10 percent, operating income rises 25 percent, and earnings per share rises 40 percent. DOL = 25% / 10% = 2.5. DFL = 40% / 25% = 1.6. DTL = 40% / 10% = 4.0, which matches DOL x DFL = 2.5 x 1.6 = 4.0.

CFA capital structure notes: exam traps to avoid

• Market value weights, not book value. WACC weights use market values, so pick the market value when a question gives both.
• The tax shield applies to debt only. Interest is deductible, and dividends are not.
• MM Proposition I flips with taxes. Without taxes, value does not change with leverage. With taxes, switch to VL = VU + t x D.
• Proposition II has two versions. The two versions differ by one term: (1 – t). Watch for the tax rate in the question stem.
• Pecking order has no target ratio. If an answer choice gives a firm a fixed optimal ratio under pecking order theory, it is wrong.

One-Page Revision

Concept	Formula or rule	Key point
WACC	wd x rd x (1 – t) + we x re	Market weights; interest is deductible
MM Proposition I, no taxes	VL = VU	Capital structure does not affect value
MM Proposition I, with taxes	VL = VU + t x D	Debt adds value via the tax shield
MM Proposition II, with taxes	re = r0 + (r0 – rd) x (D/E) x (1 – t)	Cost of equity rises with leverage
Trade-off theory	Marginal tax benefit = marginal distress cost	Gives an optimal debt ratio
Pecking order theory	Retained earnings, then debt, then equity	No target ratio
Optimal structure	Minimizes WACC, maximizes value	Firms aim at a target range
Leverage	DOL 2.5, DFL 1.6, DTL 4.0	DTL = DOL x DFL

In summary, these CFA capital structure notes cover the four learning outcomes: the WACC, the factors that shape it, the Modigliani-Miller propositions, and optimal and target capital structures. Next, read the CFA derivatives notes, and return to the free CFA notes hub.