Capital structure theories and practical considerations

Q: What is defined as the 'Capital Structure' of a company?

Capital Structure is the specific mix of Debt and Equity used by a company to finance its operations and growth.

Q: Why is debt financing generally cheaper than equity financing ( \(K_d?

Debt is cheaper because it is lower risk for the investor (lenders have priority in liquidation) and interest payments provide a Tax Shield .

Q: What is the 'Tax Shield' in capital structure?

The Tax Shield is the reduction in income taxes resulting from the tax-deductibility of interest payments on debt.

Q: What does the 'Traditional Theory' suggest about a company's WACC?

It suggests there is an optimal capital structure where WACC is minimized and firm value is maximized (the WACC curve is U-shaped).

Q: According to Modigliani and Miller (1958), why is capital structure irrelevant in a world without taxes?

Because any benefit from cheap debt is exactly offset by the increase in the cost of equity ( $K_e$) due to increased financial risk, keeping WACC constant.

Q: What is the core conclusion of M&M (1963) regarding capital structure with taxes?

Due to the tax shield on interest, the WACC will continually decrease as gearing increases, suggesting a company should be 100% debt-financed .

Q: What are the potential bankruptcy costs associated with high debt levels?

Bankruptcy costs include Direct Costs (legal and administrative fees) and Indirect Costs (loss of customers, suppliers, and key staff).

Q: What are 'Agency Costs' in relation to debt holders?

Costs arising from the conflict of interest between managers/shareholders and lenders, often manifesting as restrictive covenants .

Q: What is the 'Static Trade-off Theory'?

The idea that a firm's optimal capital structure is found by balancing the tax benefits of debt against the costs of financial distress (bankruptcy and agency costs).

Q: What is the hierarchy of the 'Pecking Order Theory'?

Firms prefer 1. Retained Earnings , followed by 2. Straight Debt , and finally 3. New Equity as a last resort.

Financial Management (FM) · ACCA · 5 min read

Welcome to Capital Structure!

In this chapter, we are going to explore one of the most interesting questions in finance: Does it matter how a company raises money?

Imagine you want to buy a car for \$10,000. You could use \$10,000 of your own savings (Equity), or you could borrow the whole \$10,000 from a bank (Debt), or a mix of both. In business, the mix of debt and equity is called the Capital Structure. Our goal is to find the "sweet spot" that makes the company as valuable as possible while keeping the cost of funds (the WACC) as low as possible.

Don't worry if this seems a bit abstract at first. We will break it down into four main theories and some real-world common sense!

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1. The Prerequisite: Why Debt is Usually Cheaper

Before we dive into theories, you must remember two things about debt:

1. Risk: Debt is safer for the lender than shares are for an investor. If a company goes bust, debt holders get paid first. Because it's lower risk, lenders accept a lower return ($K_d$).
\n2. Tax: In most countries, interest payments are tax-deductible. This makes debt even cheaper for the company. This is known as the Tax Shield.

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2. The Traditional Theory

This is the "old school" view. It suggests there is an Optimal Capital Structure where the company's value is maximized.

How it works:
\nInitially, as you replace expensive equity with cheap debt, the Weighted Average Cost of Capital (WACC) starts to fall. However, as the company takes on more and more debt, it becomes "geared up" and risky. Eventually, two things happen:
\n• Shareholders get scared and demand a much higher return ($K_e$ rises).
\n• Lenders get scared and raise interest rates ($K_d$ rises).
\nThis causes the WACC to bottom out and then start rising again.

The Takeaway: According to this theory, there is a perfect balance (an "optimal" point) that managers should try to find.

\n\n

3. Modigliani and Miller (M&M) - Part 1: No Taxes

In 1958, two economists (M&M) suggested something radical: Capital structure doesn't matter at all!

The Analogy: Imagine you have a pizza. Whether you cut it into 4 large slices or 8 small slices, it’s still the same amount of pizza. M&M argued that the value of a firm is determined by its underlying assets and earnings, not how you split those earnings between debt and equity.

The Logic:
\nAs you add cheap debt, the financial risk to shareholders increases. They immediately demand a higher return ($K_e$) that exactly offsets the benefit of the cheaper debt. Therefore, the WACC remains constant at all levels of gearing.

Quick Review: Under M&M (No Taxes), the total value of the firm remains the same regardless of its gearing.

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4. Modigliani and Miller (M&M) - Part 2: With Taxes

In 1963, M&M updated their theory to include Corporate Tax. This changed everything!

Because interest is tax-deductible, debt provides a "tax shield." The government effectively pays for part of your financing. Therefore, the more debt you have, the lower your WACC becomes and the higher the value of your firm.

The Formula:
\n$V_L = V_U + (T \times D)$
\n(Value of Leavered/Geared firm = Value of Ungeared firm + Tax rate × Debt amount)

The Conclusion: Companies should be financed almost 100% by debt to maximize value.

Wait! Did you know? In the real world, we almost never see companies with 100% debt. This suggests M&M's second theory is missing some "real-world" problems.

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5. Real-World Practical Considerations

Why don't companies just load up on 100% debt? Here are the "Practical Considerations" you need for your FM exam:

Bankruptcy Costs:
\nAs debt increases, the chance of going bust increases. There are Direct Costs (legal fees, liquidators) and Indirect Costs (customers stop buying because they fear the company won't exist to honor warranties; talented staff leave).

Agency Costs:
\nLenders (debt holders) don't trust managers completely. They might impose restrictive covenants (rules) like "you cannot pay a dividend if your cash drops below \$X." These restrictions cost money and time to manage.

Tax Exhaustion:
The tax shield only works if you are making a profit. If a company is losing money, extra debt provides no tax benefit because there is no tax to "shield" anyway!

Key Takeaway: The Static Trade-off Theory says companies try to find a balance between the benefits of the tax shield and the costs of potential bankruptcy.

6. Pecking Order Theory

This theory says managers don't actually look for a "perfect" mix. Instead, they follow the path of least resistance based on Asymmetric Information (the idea that managers know more about the firm than outside investors).

Managers follow a "Pecking Order" when they need money:
1. Retained Earnings: (Use your own cash first. It’s free to arrange and doesn't send bad signals to the market).
2. Straight Debt: (If cash runs out, borrow money. It's cheaper than issuing shares).
3. New Equity: (The absolute last resort. Issuing new shares is expensive and often signals to the market that the current share price is too high).

Memory Aid: Think of it like a teenager asking for money. First, you check your own piggy bank (Retained Earnings). If that’s empty, you ask for a loan (Debt). If all else fails, you ask your parents to buy into your business (Equity)!

7. Other Practical Factors for the FM Exam

When answering a written question about capital structure, consider these points:
• Industry Norms: If all your competitors have 20% gearing, having 80% gearing makes you look very risky.
• Control: Issuing new shares might mean the current owners lose control of the company. Debt doesn't usually carry voting rights.
• Flexibility: If you use up all your borrowing capacity now, you won't have any "emergency" debt available if a great opportunity comes up later.
• Interest Cover: Can the company actually afford the annual interest payments from its operating profit?

Summary Quick Review Box

Traditional View: There is an optimal mix; WACC is U-shaped.
M&M (No Tax): Gearing is irrelevant; WACC is constant.
M&M (With Tax): 100% debt is best due to the tax shield.
Pecking Order: Use internal funds, then debt, then equity.
Real World: Trade-off between tax shields and bankruptcy costs.

Common Mistake to Avoid: Many students think "gearing" is just debt. Remember, Gearing is the relationship between debt and equity. If you increase debt while keeping equity the same, your gearing ratio goes up!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is defined as the 'Capital Structure' of a company?

Capital Structure is the specific mix of Debt and Equity used by a company to finance its operations and growth.

Why is debt financing generally cheaper than equity financing ( $K_d < K_e$)?

Debt is cheaper because it is lower risk for the investor (lenders have priority in liquidation) and interest payments provide a Tax Shield.

What is the 'Tax Shield' in capital structure?

The Tax Shield is the reduction in income taxes resulting from the tax-deductibility of interest payments on debt.

What does the 'Traditional Theory' suggest about a company's WACC?

It suggests there is an optimal capital structure where WACC is minimized and firm value is maximized (the WACC curve is U-shaped).

According to Modigliani and Miller (1958), why is capital structure irrelevant in a world without taxes?

Because any benefit from cheap debt is exactly offset by the increase in the cost of equity ( $K_e$) due to increased financial risk, keeping WACC constant.

What is the core conclusion of M&M (1963) regarding capital structure with taxes?

Due to the tax shield on interest, the WACC will continually decrease as gearing increases, suggesting a company should be 100% debt-financed.

What are the potential bankruptcy costs associated with high debt levels?

Bankruptcy costs include Direct Costs (legal and administrative fees) and Indirect Costs (loss of customers, suppliers, and key staff).

What are 'Agency Costs' in relation to debt holders?

Costs arising from the conflict of interest between managers/shareholders and lenders, often manifesting as restrictive covenants.

What is the 'Static Trade-off Theory'?

The idea that a firm's optimal capital structure is found by balancing the tax benefits of debt against the costs of financial distress (bankruptcy and agency costs).

What is the hierarchy of the 'Pecking Order Theory'?

Firms prefer 1. Retained Earnings, followed by 2. Straight Debt, and finally 3. New Equity as a last resort.

How do 'Industry Norms' and 'Control' affect capital structure decisions?

Companies often stay close to industry average gearing to avoid appearing risky, and may prefer debt to avoid diluting the control of existing shareholders.

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