How does capital structure affect cost of capital?

Capital structure—the mix of debt and equity a firm uses—affects the firm’s overall cost of capital through tax effects, risk transfer between claimants, and the probability of financial distress. The weighted average cost of capital aggregates the required returns for debt and equity; changing the proportions alters incentives and perceived risk for investors, and that in turn shifts those required returns.

Basic theory and tax effects
Franco Modigliani of the Massachusetts Institute of Technology and Merton Miller of the University of Chicago established the foundational result that in a frictionless world without taxes or bankruptcy costs, capital structure does not change the firm’s value or its weighted average cost of capital. When corporate taxes are introduced, Modigliani and Miller showed that interest is tax-deductible and debt provides a tax shield that can lower the firm’s after-tax cost of capital. Real-world frictions, however, mean the tax advantage of debt is only one part of the story.

Trade-offs, agency costs, and practical outcomes
Stewart C. Myers of MIT Sloan developed the trade-off perspective that firms balance the tax benefits of debt against expected costs of financial distress and bankruptcy. As leverage rises, equity holders demand higher returns to compensate for increased risk, which raises the cost of equity. At high leverage, the combined effect can increase the weighted average cost of capital despite tax shields, because default risk and agency costs—conflicts between managers, debt holders, and shareholders—become material. Empirical and theoretical research emphasizes that capital structure affects not just headline borrowing costs but also investment behavior: higher expected distress costs can force firms to scale back long-term projects.

Human and territorial nuances
Raghuram G. Rajan of the University of Chicago Booth highlights how institutional context shapes financing choices. In countries where banks dominate and bankruptcy procedures are slow, firms often face higher effective borrowing costs and stronger constraints on restructuring, which raises the cost of capital for riskier investments. Cultural norms around creditor rights, family ownership, and trust in public institutions influence whether firms prefer bank loans, informal financing, or equity and thus alter how capital structure translates into financing costs. In resource-rich or environmentally sensitive territories, high leverage can reduce a company’s capacity to invest in remediation or community engagement, with social consequences for employment and local ecosystems.

Consequences for strategy and policy
Because capital structure changes both explicit interest costs and the required return on equity, corporate managers and policymakers must weigh short-term tax advantages against long-term risks to solvency, innovation, and social license to operate. Regulatory frameworks, transparency, and predictable insolvency rules lower the costs associated with debt and can make tax-efficient financing more attractive. Conversely, weak institutions and higher default frictions magnify the downside of leverage, raising the firm’s overall cost of capital and constraining growth and investment.