Business Finance · Cost of capital and evaluating investment projects

Sources of Finance and Capital Structure: Equity vs Debt Explained

Updated 11 October 2026 · Fact-checked

Sources of finance are the ways a firm raises money: equity, debt and hybrids such as convertibles and preference shares. Capital structure is the mix of these. To answer exam questions, list each source's cost, risk, control and tax effect, then apply Modigliani-Miller and the trade-off theory to judge the best mix.

Understand Sources of Finance and Capital Structure

A company needs money to buy assets and run its business. It can get that money from its owners or from lenders. Money from owners is equity. Money from lenders is debt. Instruments that mix features of both are hybrids.

Equity (ordinary shares) gives owners a residual claim. They are paid only after lenders. Dividends are not compulsory, and there is no repayment date. Because equity holders bear the most risk, they demand the highest return. Retained profits are also equity, and they are the main internal source of finance.

Debt (loans, bonds, debentures) means fixed interest and repayment of the principal on a set date. Lenders rank ahead of shareholders and often hold security over assets. Debt is cheaper than equity because it is less risky for the investor. In most tax systems interest is deductible before tax, which lowers the true cost further. But missed payments can lead to default and liquidation.

Hybrids include preference shares, convertible bonds and warrants. A convertible bond pays interest like debt but can be exchanged for shares. This lets the firm pay a lower coupon now, at the price of possible dilution later.

Capital structure is the proportion of debt and equity. Gearing (leverage) measures how much debt a firm uses. Modigliani-Miller (MM) showed that, with no taxes, no bankruptcy costs and perfect markets, firm value does not depend on the mix. With corporate tax, debt adds value through the tax shield. The trade-off theory says firms balance this tax benefit against the expected cost of financial distress. That gives an optimal gearing level. The pecking order view adds that firms prefer internal funds, then debt, then new equity, because of information differences between managers and investors.

Key rules to remember

Gearing ratio (debt to equity): Gearing = D ÷ E; D and E should be stated on a consistent basis, preferably market values. Some texts use D ÷ (D + E). State the definition you use.
MM Proposition I (no tax): V_L = V_U; Value of a levered firm equals value of an unlevered firm. Holds under perfect markets, no taxes and no distress costs.
MM Proposition II (no tax): k_e = k_0 + (k_0 − k_d) × D ÷ E; Cost of equity rises linearly with gearing. k_0 is the overall cost of capital. Assumes risk-free-style debt cost k_d is constant.
MM Proposition I (with corporate tax): V_L = V_U + T × D; T is the corporate tax rate. Assumes permanent debt and no distress costs. T × D is the present value of the tax shield.
Annual tax shield on interest: Tax shield = T × interest; Interest is assumed tax deductible.
After-tax cost of debt: k_d(1 − T); Use when interest is tax deductible and the firm pays tax.
Trade-off theory: V_L = V_U + PV(tax shield) − PV(distress costs); Optimal gearing is where the marginal tax benefit equals the marginal expected distress cost.

How to solve Sources of Finance and Capital Structure questions

Use this method for both descriptive and numerical questions on sources of finance and capital structure.

1Read the question and identify what is asked: compare sources, recommend a source, or compute value or cost under a theory.
2Note the firm's situation: listed or unlisted, profitable or loss-making, existing gearing, growth stage, tax status and asset base.
3For descriptive questions, assess each source on cost, risk, control, flexibility, tax treatment and availability.
4For numerical questions, write down the assumptions of the theory used (tax or no tax, distress costs, debt type).
5Choose the right formula: MM I or II for value and cost of equity, and tax shield for the tax case.
6Compute step by step, showing units and the formula in words before numbers.
7Link the result to a decision: more debt, less debt or a hybrid, and why.
8State limitations or assumptions that could change the answer, such as distress costs or market imperfections.

Quickest way: Four-lens check for choosing finance

When to use it: Use this in multiple-choice questions and short written parts when you must pick or justify a source of finance quickly.

Cash flow: are earnings stable enough to carry fixed interest? If not, lean to equity.
Tax: is the firm paying tax? If yes, debt gives a tax shield.
Control: will new shares dilute existing owners? If that matters, prefer debt or retained profit.
Existing gearing: is the firm already highly geared? If so, more debt raises distress risk.
For MM questions, first ask: is there tax? No tax means value is unchanged by gearing. Tax means V_L = V_U + T × D.

Common mistakes in Sources of Finance and Capital Structure

Saying MM proves that capital structure never matters in real life.
Students forget that MM rests on strict assumptions.
Fix: State that the no-tax result holds only in perfect markets. Real firms face taxes, distress costs and information gaps.
Using the pre-tax cost of debt when tax applies.
The tax adjustment is skipped under time pressure.
Fix: Check the question for a tax rate. If interest is deductible, use k_d(1 − T).
Claiming debt is always cheaper and so a firm should use as much as possible.
Students stop at the lower coupon and ignore risk.
Fix: Explain that more debt raises the cost of equity and distress risk. Trade-off theory gives an interior optimum.
Treating preference shares as plain equity or plain debt.
They are legally shares but pay a fixed dividend.
Fix: Describe them as hybrid. Dividends are fixed, usually cumulative, and paid before ordinary dividends. Dividends are generally not tax deductible.
Mixing book values and market values in gearing calculations.
Balance sheet figures are easier to find.
Fix: Use market values for cost of capital and MM work unless the question gives only book values. State your basis.
Forgetting that retained profits have a cost.
Retained profit looks free because no payment is made.
Fix: Say that retained earnings belong to shareholders, who expect the cost of equity on them.

Worked examples

Example 1

An unlevered firm has value ₹50 crore. It issues permanent debt of ₹20 crore. The corporate tax rate is 25%. Ignoring distress costs, find the value of the levered firm under MM with tax.

Show the solution

Use V_L = V_U + T × D.
Tax shield = 0.25 × ₹20 crore = ₹5 crore.
V_L = ₹50 crore + ₹5 crore = ₹55 crore.

Answer: The levered firm is worth ₹55 crore.

Example 2

With no taxes, a firm has an overall cost of capital k_0 = 10% and cost of debt k_d = 6%. Its debt to equity ratio is 0.5. Find the cost of equity under MM Proposition II.

Show the solution

Use k_e = k_0 + (k_0 − k_d) × D ÷ E.
k_0 − k_d = 10% − 6% = 4%.
Multiply by D ÷ E: 4% × 0.5 = 2%.
k_e = 10% + 2% = 12%.

Answer: The cost of equity is 12%.

Exam tips

Always state the assumptions behind MM before giving its result. Markers award marks for them.
In written answers, compare sources on at least cost, risk, control and tax. Use a short bullet for each.
For recommendation questions, tie your choice to the firm's facts in the case, such as stable cash flows or high existing gearing.
In multiple-choice questions, check whether tax is mentioned. It changes the MM answer.
Show the formula and each step in numerical parts, even for simple calculations.

Practice questions from Cost of capital and evaluating investment projects

Sources of Finance and Capital Structure in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Sources of Finance and Capital Structure: frequently asked questions

What is the main difference between debt and equity financing?

Debt carries fixed interest and repayment, and lenders rank ahead of shareholders. Equity has no fixed payment and no repayment date, but owners share in profits and control. Equity is riskier for the investor, so it costs more.

What does Modigliani-Miller say about capital structure?

Without taxes and other imperfections, firm value does not depend on the debt-equity mix. With corporate tax and tax-deductible interest, value rises with debt by the tax shield, T × D under the permanent debt assumption.

What is the trade-off theory of capital structure?

It says firms choose gearing by balancing the tax benefit of debt against the expected cost of financial distress. The optimal level is where an extra unit of debt adds as much distress cost as tax benefit.

Is a convertible bond debt or equity?

It is a hybrid. Until conversion it pays interest and ranks as debt. On conversion it becomes shares. Its coupon is usually lower than straight debt because holders get the conversion option.