Three Fallacies of Capital Structure

Interactive tool for Lecture 15 (Alt): The misconceptions that trap practitioners

Fallacy 1: "Debt is Cheaper" (WACC Fallacy)

The Argument: "Debt costs 4%, equity costs 13%, so let's use more debt to lower our weighted average cost of capital. Simple math!"
Cost of Equity (rE): --
WACC (before taxes): --
WACC (after taxes): --
rE = r0 + (r0 -- rD) × (D/E)
Why This is Wrong: When you issue more debt, equity becomes riskier because debt holders have priority. Equity investors demand higher returns. The cost of equity (rE) rises, offsetting the benefit of cheaper debt. Result: WACC stays constant!
The Truth (MM Proposition II): WACC is constant regardless of capital structure (without taxes). The firm's operating risk is unchanged -- it's just sliced differently between debt and equity. You can't lower your cost of capital by rearranging the slice.

WACC Components as D/E Increases

Notice: rE rises, rD flat, WACC constant (no taxes). With taxes, WACC falls slightly.

Fallacy 2: "Debt is Better When It Increases EPS" (EPS Fallacy)

The Argument: "If we leverage up, EPS goes higher in the good years. That looks great! Shareholders love growth."

Good Year EPS:

All-Equity EPS: --
Leveraged EPS: --

Bad Year EPS:

All-Equity EPS: --
Leveraged EPS: --

Volatility:

EPS Std Dev (All-Equity): --
EPS Std Dev (Leveraged): --
Why This is Wrong: Yes, EPS is higher in good years. But it's also MUCH lower (or negative) in bad years. You've amplified earnings volatility (financial leverage). The tradeoff is risk, not free returns.

EPS vs EBIT: The Break-Even Analysis

At low EBIT, leverage crushes EPS. At high EBIT, it boosts EPS. But shareholders pay the cost of increased risk.

The Truth: This is a risk-return tradeoff, not value creation. Leverage amplifies returns -- up AND down. Shareholders demand higher returns for bearing this risk. The expected return on equity rises by (r0 -- rD) × (D/E), exactly offsetting the EPS amplification.

Fallacy 3: "Investors Prefer Debt" (Clientele / Win-Win Fallacy)

The Argument: "Different investors want different securities. Some want bonds (retirees, low risk), some want equity (young, high risk tolerance). By issuing both, we satisfy both groups and create value!"
The Flaw -- Homemade Leverage: An investor can replicate any firm's capital structure on their own. If you want a 60% leveraged return, you don't need the firm to borrow -- you can borrow yourself.

Scenario: Firm Issues 30% Debt

Scenario: You Want Different Leverage

Can You Achieve Your Desired Leverage?

Your Leverage vs Firm Leverage: --
Strategy: If you want MORE leverage: borrow money personally to buy more firm equity. If you want LESS leverage: use equity to buy firm debt instead.
The Truth: Any investor can unbundle and rebundle the firm's capital structure on their own. There's no unsatisfied clientele. The firm can't create value by issuing specific securities -- investors have perfect substitutes.
Implication: If someone argues that a specific capital structure creates value because it satisfies investor preferences, ask: "Why can't investors achieve this on their own?" If they can't give a good answer, the argument is suspect.

Summary: When Arguments About Capital Structure are Valid

Fallacy 1: "Debt is Cheaper"
Assumption Violated: Ignoring MM Proposition II (cost of equity rises with leverage)
Valid When: You account for the rising cost of equity. Compare expected returns, not just cost-of-capital numbers.
Fallacy 2: "Debt Increases EPS"
Assumption Violated: Treating EPS as a value metric when it's just an accounting measure
Valid When: You account for increased risk. Higher EPS with higher risk doesn't create shareholder value.
Fallacy 3: "Investors Prefer Debt"
Assumption Violated: Assuming investors can't create homemade leverage
Valid When: Capital markets are segmented or frictions exist (e.g., retail investors can't borrow cheaply, transaction costs matter).
The Meta-Rule: If someone proposes a capital structure argument, ask: "Which MM assumption are they violating?" The valid assumptions are:
  • No taxes
  • No bankruptcy costs
  • No information asymmetry
  • No agency costs
  • Investors have access to capital markets
If they can point to a REAL market friction that violates one of these, the argument has legs. If not, it's likely a fallacy.
Bottom Line for Practitioners: Most real capital structure decisions involve taxes, bankruptcy costs, or information asymmetry -- not investor preferences. Focus on those. The fallacies often come from ignoring the real frictions that actually matter.