Equity and capital structure

9 min read

Two companies own identical assets and earn identical operating profit. One is funded entirely by shareholders and one is funded 60% by lenders. They are the same business and very different investments, and the reason is one ordered list.

The order

Who gets paid, in what order

	Return	Risk
Secured debt	Contractual, lowest	Claims specific assets first
Senior unsecured debt	Contractual	Ranks behind secured, ahead of the rest
Subordinated debt	Contractual, higher	Paid after senior, before equity
Preferred stock	Fixed dividend	Ahead of common, behind all debt
Common equity	Whatever is left	Last in line, unlimited upside

Return rises going down the list because risk rises going down the list, and both rise for the same reason: everything above you gets paid first. That is not a market convention. It is a legal order that survives bankruptcy, and it is why is always above .

What leverage does

Worked example

The same business, two structures

A business worth $1,000 generating $100 of operating profit. Case one is all equity: the shareholders own $1,000 and earn $100, a 10% return.

Case two is $600 of debt at 6% and $400 of equity. Interest is $36, so equity earns $64 on $400, a 16% return. Leverage improved the equity return by six points with no operational change at all.

Now the business has a bad year and operating profit falls to $50. The all-equity company earns 5%. The levered company pays $36 of interest and earns $14 on $400, a 3.5% return. Profit halved and the levered equity return fell by more than three quarters.

At $36 of operating profit the levered company earns nothing. Below that it cannot pay its interest, and the lenders, who rank first, start making the decisions.

The running example carries about 1.3x to , which is conservative for a retailer. A buyout of the same business at five turns would not change a single thing about how it operates and would change everything about how risky its is.

Why any debt at all

Because interest is tax deductible and are not. A company paying 6% on debt with a 25% tax rate has an after-tax cost of 4.5%, and the government funded the difference. That subsidy is real and it is the main reason optimal are not zero debt.

Against it sits the cost of financial distress, which starts well before bankruptcy. A levered company negotiating with suppliers gets worse terms. Customers signing multi-year contracts ask about the . Good employees read the news. None of that appears in a calculation and all of it is real.

Test yourself

01A company's enterprise value falls 20%. What happens to its equity if it is levered 5x EBITDA at a 9x multiple?

Enterprise value goes from 9x to 7.2x EBITDA. Debt is still 5x. Equity was 4x and is now 2.2x, so it fell 45% on a 20% move in the business. Leverage does not create risk, it concentrates the existing risk onto a smaller base. The same arithmetic runs the other way on the upside, which is the entire appeal.

02Why does preferred stock get subtracted in the bridge to equity value?

Because it ranks ahead of common. Enterprise value covers the whole capital structure, and preferred holders have a claim on part of it before common shareholders see anything. It behaves like debt in the bridge even though accounting classifies it as equity, which is a good example of why you follow the economics rather than the label.

03Under Modigliani-Miller, capital structure does not affect firm value. Why does it obviously matter in practice?

Because the theorem assumes no taxes, no bankruptcy costs, and no information asymmetry. Interest is deductible, so debt genuinely creates value up to a point. Financial distress has real costs: customers leave, suppliers tighten terms, good people go. The trade-off between those two is why an optimal structure exists at all, and why it differs so much between a utility and a biotech.

A tutor that knows this lesson. It asks before it explains, and it will not tell you what to do with your own money.

Every figure in this lesson that names a company comes from Target Corporation's Form 10-K for Fiscal 2025, the year ended 2026-01-31, filed 2026-03-11. Educational material, not investment advice.