In perfect markets:
VL = VU

Where:
VL = Value of levered firm
VU = Value of unlevered firm

Implication: Capital structure irrelevant

Cost of Equity:
rE = rA + (rA - rD) × D/E

Where:
rE = Cost of equity
rA = Cost of assets (unlevered)
rD = Cost of debt
D/E = Debt-to-equity ratio

Value with taxes:
VL = VU + TC × D

Tax Shield Value = TC × D
Where TC = Corporate tax rate

Implication: 100% debt optimal (unrealistic)

Optimal Capital Structure balances:

Benefits of Debt          vs.        Costs of Debt
├── Tax shields                      ├── Financial distress
├── Reduced agency costs             ├── Agency costs of debt
└── Signaling effects                └── Loss of flexibility

Optimal point: Marginal benefit = Marginal cost

Financing Hierarchy:
1. Internal funds (retained earnings)
   ↓ (exhausted)
2. Debt financing
   ↓ (capacity reached)
3. Equity financing (last resort)

Driven by information asymmetry

Issue equity when overvalued
Issue debt when undervalued

Capital structure = Cumulative outcome of timing attempts

WACC = (E/V) × rE + (D/V) × rD × (1-TC)

Where:
E = Market value of equity
D = Market value of debt
V = E + D = Total firm value
rE = Cost of equity
rD = Cost of debt
TC = Corporate tax rate

rE = rf + β × (rm - rf)

Where:
rf = Risk-free rate
β = Beta (systematic risk)
rm = Market return
(rm - rf) = Market risk premium

βL = βU × [1 + (1-TC) × D/E]

Where:
βL = Levered beta
βU = Unlevered beta

Firm Value = FCF / (WACC - g)

Lower WACC → Higher Firm Value

Example:
FCF = $100M, g = 3%
WACC = 10%: Value = $1,429M
WACC = 9%: Value = $1,667M
WACC = 8%: Value = $2,000M

Risk Assessment:
┌─────────────────┬────────────────┐
│ Low Risk        │ High Risk      │
├─────────────────┼────────────────┤
│• Stable cash    │• Volatile cash │
│  flows          │  flows         │
│• Mature         │• Growth/tech   │
│  industries     │  companies     │
│• Tangible       │• Intangible    │
│  assets         │  assets        │
│→ Higher debt    │→ Lower debt    │
│  capacity       │  capacity      │
└─────────────────┴────────────────┘

Tax Shield Value:
Annual Tax Shield = Interest × Tax Rate
PV of Tax Shield = (D × rD × TC) / rD = D × TC

Example:
Debt = $1B, Tax Rate = 30%
Tax Shield Value = $300M

Expected Distress Cost = Probability × Cost
High leverage → Higher probability → Higher expected cost

Problem: Manager-shareholder conflicts
Solutions through debt:
- Reduces free cash flow
- Increases discipline
- Aligns interests

Problems:
- Asset substitution
- Underinvestment
- Wealth transfer

Solutions:
- Covenants
- Convertible debt
- Shorter maturity

Market Factors:
├── Interest rate environment
├── Credit market conditions
├── Equity market valuations
├── Investor sentiment
└── Regulatory environment

Step-by-Step Process:
1. Calculate current WACC
2. Model WACC at different D/E ratios
3. Consider constraints
4. Find minimum WACC point
5. Assess implementation feasibility

WACC
  ^
  |     \
  |      \___
  |          \___    ___/
  |              \_/
  |               ^
  |           Optimal
  +-------------------> D/E Ratio

APV = NPV of project (all-equity) + PV of financing effects

APV = NPVbase + PVtax shield - PVdistress costs - PVagency costs

Example:
Base NPV: $100M
Tax shield: +$30M
Distress costs: -$10M
Agency costs: -$5M
APV: $115M

Target Rating Approach:
┌─────────┬────────┬────────┬─────────┐
│ Rating  │ D/E    │ WACC   │ Default │
│         │ Ratio  │        │ Risk    │
├─────────┼────────┼────────┼─────────┤
│ AAA     │ 0.1    │ 8.5%   │ 0.01%   │
│ AA      │ 0.3    │ 8.2%   │ 0.02%   │
│ A       │ 0.5    │ 8.0%   │ 0.05%   │
│ BBB     │ 0.8    │ 8.1%   │ 0.20%   │
│ BB      │ 1.5    │ 8.8%   │ 1.00%   │
└─────────┴────────┴────────┴─────────┘
Target: A rating for optimal balance

Peer Comparison:
Company A: D/E = 0.4, EV/EBITDA = 12x
Company B: D/E = 0.6, EV/EBITDA = 11x
Company C: D/E = 0.5, EV/EBITDA = 13x
Industry Avg: D/E = 0.5

Our Company: D/E = 0.2 → Underleveraged?

Economic Scenarios:
                Base    Recession   Boom
EBITDA          $100M   $60M       $150M
Interest coverage:
- Current (20% debt)  10x     6x         15x
- Optimal (40% debt)  5x      3x         7.5x
- Aggressive (60%)    3.3x    2x         5x

Choose structure that survives downside

Capital Structure Evolution:
Stage           Optimal Structure       Rationale
─────────────────────────────────────────────────
Startup         100% Equity            High risk
Growth          80-90% Equity          Flexibility
Expansion       60-70% Equity          Growth funding
Maturity        40-60% Equity          Stable cash
Decline         30-50% Equity          Cash return

Opportunistic Financing:
Stock Price High → Issue Equity
                   - Reduce leverage
                   - Build war chest

Interest Rates Low → Issue Debt
                     - Lock in cheap funding
                     - Refinance expensive debt

Credit Spreads Tight → Extend maturities
                       - Improve flexibility

Financial Flexibility Framework:
┌─────────────────────────────────┐
│    Unused Debt Capacity         │
├─────────────────────────────────┤
│ • Investment opportunities      │
│ • Competitive responses         │
│ • Economic downturns           │
│ • Acquisition currency         │
└─────────────────────────────────┘

Target: Maintain 20-30% buffer

Increasing Leverage:
- Bond issuance
- Term loans
- Revolving credit
- Sale-leaseback

Decreasing Leverage:
- Debt repayment
- Equity issuance
- Asset sales
- Retained earnings

Buyback Impact:
Before: E = $1B, D = $500M, D/E = 0.5
Buyback: $200M debt-financed
After: E = $800M, D = $700M, D/E = 0.875

EPS Impact:
Shares: 100M → 80M
Net Income: $120M → $114M (after interest)
EPS: $1.20 → $1.425 (+18.75%)

Leverage Impact:
High dividends → External financing need
Low dividends → Internal equity building

Special dividends → One-time leverage increase
Regular increases → Gradual leverage drift

Tools Available:
├── Debt Refinancing
│   ├── Lower rates
│   ├── Better terms
│   └── Extended maturity
├── Debt-for-Equity Swaps
│   ├── Reduce leverage
│   └── Eliminate distress
└── Hybrid Securities
    ├── Convertible bonds
    ├── Preferred stock
    └── Warrants

Cash Flow Enhancement:
- Cost reduction
- Working capital optimization
- Asset monetization
- Business model changes

→ Support higher leverage

Acquisition Financing Mix:
Target Value: $1B
┌────────────┬────────┬─────────┐
│   Cash     │  Debt  │ Stock   │
├────────────┼────────┼─────────┤
│   $200M    │ $500M  │ $300M   │
│    20%     │  50%   │  30%    │
└────────────┴────────┴─────────┘

Post-merger leverage optimization required

Multi-Currency Capital Structure:
- Natural hedging opportunities
- Tax optimization
- Regulatory constraints
- Local market access

Example:
EU Operations → EUR debt
US Operations → USD debt
Match cash flows and obligations

Characteristics:
- High growth
- Intangible assets
- Volatile cash flows
- Stock options

→ Lower optimal leverage (0-30% debt)

Characteristics:
- Stable cash flows
- Tangible assets
- Regulated returns
- Capital intensive

→ Higher optimal leverage (50-70% debt)

Key Leverage Metrics:
┌─────────────────┬─────────┬─────────┐
│ Metric          │ Current │ Target  │
├─────────────────┼─────────┼─────────┤
│ Debt/EBITDA     │ 3.5x    │ 2.5-3.0x│
│ EBITDA/Interest │ 5.0x    │ >6.0x   │
│ Debt/Equity     │ 0.8x    │ 0.5-0.6x│
│ FFO/Debt        │ 25%     │ >30%    │
└─────────────────┴─────────┴─────────┘

Stress Scenarios:
1. Revenue -30%
2. EBITDA margin -500bps
3. Interest rates +300bps
4. Refinancing unavailable

Test: Can structure survive?

Flexibility Levers:
Operational          Financial
├── Cost cuts        ├── Credit lines
├── Capex defer      ├── Asset sales
├── Working capital  ├── Equity issue
└── Pricing actions  └── Debt restructure

Quarterly Review:
□ Market conditions
□ Business performance  
□ Peer comparisons
□ Rating agency views
□ Investor feedback

Triggers for Action:
- Rating downgrade threat
- Covenant pressure
- M&A opportunity
- Market dislocation

Capital Structure Dashboard:
┌────────────────────────────────────┐
│  Leverage Metrics      │ Status    │
├────────────────────────┼───────────┤
│ Net Debt/EBITDA: 2.8x  │    ✓      │
│ Interest Coverage: 7.2x │    ✓      │
│ Credit Rating: A-      │    ✓      │
│ WACC: 8.2%            │    !      │
│ Debt Capacity: $500M   │    ✓      │
└────────────────────────┴───────────┘

1990s-2000s: Zero debt policy
- Tech company conservatism
- Stock option considerations
- High cash generation

2009+: Debt issuance begins
- Take advantage of low rates
- Fund buybacks/dividends
- Optimize WACC

Current: ~$50B debt, AAA rating
- Balanced approach
- Tax efficiency
- Financial flexibility

Pre-2013: No debt
2013+: Major debt program
- Fund capital returns
- Avoid repatriation taxes
- Exploit rate environment

Results:
- >$100B returned to shareholders
- Maintained flexibility
- Optimized cost of capital

Capital Structure Review Process:
1. Annual strategic review
2. Quarterly monitoring
3. Event-driven analysis
4. Continuous optimization

Key Success Factors:
- Board engagement
- Clear communication
- Disciplined execution
- Long-term perspective

Excel Model Components:
├── Current capital structure
├── WACC calculation
├── Scenario analysis
├── Credit metrics
├── Valuation impact
└── Implementation plan