Every company is funded from two sources. Equity is money from shareholders that is never repaid and ranks last in the queue. Debt is money from lenders that must be repaid on fixed dates with interest, and ranks first. The mix between them is the capital structure, and two companies running identical operations can be completely different investments purely because of it.
Borrowing magnifies outcomes in both directions. A business earning £100m on £1,000m of assets returns 10% to shareholders if funded entirely by equity. Funded half by debt at 6%, the same £100m becomes £70m after interest on a £500m equity base — a 14% return. But when profit falls by a third to £67m, the equity-funded return falls proportionally to 6.7% while the borrowed version falls to 7.4%, nearly half, because the £30m interest bill does not fall with profits.
The weighted average cost of capital blends what shareholders require with the after-tax cost of debt, in proportion to how much of each is used. A company funded 70% by equity at 9% and 30% by debt at 5% before a 25% tax rate has a cost of capital of 7.4%. That is the hurdle the return on invested capital has to clear, and it is the discount rate a reverse discounted cash flow depends on.
The module closes on capital allocation: the five things management can do with money, and why the timing of share buybacks is the cleanest available test of a management team. Boeing repurchased roughly $43bn of its own shares between 2013 and 2019, ended 2019 with equity of negative $8.6bn, and sold about $22bn of new shares in October 2024 at far lower prices.
Educational, not investment advice.