## **Learning Outcomes**

After reading this article, you will be able to explain the core capital structure theories, the meaning and significance of target capital structure, and financial flexibility. You will recognise how these principles inform real-world financial decisions, the trade-offs involved in setting target gearing levels, and the importance of flexibility in a company’s capital management. You will also be equipped to apply these concepts in exam scenarios involving the analysis or recommendation of funding strategies.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand both the theory and practice of capital structure decisions. Revision in this area should focus on:

- The main theories of capital structure: traditional, Modigliani-Miller, pecking order, and static trade-off
- Setting and maintaining a target capital structure (target gearing ratio)
- The importance of financial flexibility in corporate financing decisions
- The practical implications and behavioural influences affecting real-world capital structure choices
- Interplay between capital structure policy, cost of capital, value, and risk

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which theory explains companies’ preference to fund new investments first with retained earnings, then debt, then equity?
2. What does "financial flexibility" refer to in capital structure management?
3. True or false? According to the Modigliani-Miller theory with tax, increasing debt indefinitely always reduces the company’s weighted average cost of capital (WACC).
4. List one reason why a firm might intentionally deviate from its optimal or target capital structure.

## **Introduction**

Selecting the right capital structure—the mix of debt and equity finance—is a fundamental long-term decision facing all financial managers. Theory suggests there is an optimal structure that maximises firm value, but in practice, real companies must balance risk, costs, and flexibility when deciding their target gearing. This article outlines key capital structure theories, the concept of target structure, the role of financial flexibility, and practical factors that influence decision-making beyond simplistic models.

> **Key Term: capital structure**
> The relative proportions of debt and equity used to finance a company’s assets and operations.
>
> **Key Term: target capital structure**
> A specific mix of debt and equity funding selected by a company as an intended long-run average or range for its capital base.

## THEORIES OF CAPITAL STRUCTURE

### Traditional Theory

The traditional view, sometimes called the intuitive approach, suggests that increasing gearing initially reduces the WACC as debt is cheaper than equity. However, higher gearing raises financial risk and, eventually, the cost of both debt and equity. This results in a minimum point (i.e., an “optimal” gearing).

> **Key Term: weighted average cost of capital (WACC)**
> The average rate a firm pays to finance its assets, weighted by the market value proportions of each capital source.

### Modigliani-Miller Theorem

Modigliani and Miller (M&M) proved, under restrictive assumptions (no tax, no bankruptcy risk), that capital structure is irrelevant to firm value. When corporate tax is included, their theory states that increasing debt (for which interest is tax-deductible) continually lowers WACC and raises firm value. However, in reality, costs such as bankruptcy, agency, and practical constraints prevent indefinite increases in gearing.

> **Key Term: static trade-off theory**
> The concept that firms balance the tax benefits of additional debt against the rising costs of financial distress, aiming to achieve an optimal, stable level of gearing.

### Pecking Order Theory

Pecking order theory proposes that firms have a funding hierarchy: they prefer to use internally generated funds, then debt, and finally new equity. This reflects managers’ desire to avoid signalling to the market that shares are overvalued, and to avoid costs and scrutiny associated with new equity.

> **Key Term: pecking order theory**
> A theory stating firms prefer internal finance, then debt, and issue equity only as a last resort, primarily due to asymmetric information and signalling effects.

### Financial Flexibility and Agency Costs

Financial flexibility means maintaining the capacity to quickly raise funds when needed (e.g., to seize opportunities or survive adverse events), even if it means operating below the theoretical optimal gearing. Agency costs further influence structure due to conflicts between shareholders, managers, and lenders.

> **Key Term: financial flexibility**
> The ability of a company to access funding on reasonable terms when required and to adjust its capital structure in response to unforeseen events or investment opportunities.

## TARGET CAPITAL STRUCTURE IN PRACTICE

Real companies rarely operate at a single fixed gearing ratio. Instead, management sets a target range reflecting strategic aims, appetite for risk, industry norms, and economic conditions.

Factors influencing target capital structure include:

- Business risk: Firms with volatile cash flows avoid high debt.
- Tax position: Tax-exhausted firms have less incentive to use debt.
- Asset base: Tangible assets provide security for lenders.
- Growth prospects: High-growth firms require financial flexibility.
- Market conditions: Interest rates, investor sentiment, and capital market trends.
- Covenants: Restrictions attached to existing debt may limit future borrowing.

### Maintaining the Target Structure

Shifts in capital structure occur over time due to profit retention, debt redemption, or market valuation changes (“gearing drift”). Management may rebalance through share buybacks, new issues, or changes in dividend policy.

### **Worked Example 1.1**

A technology firm has set a target gearing of 40% debt to total capital (by market value). Following several years of high retained earnings, the company’s debt falls to 30% of capital. Management is considering options to return to the target structure.

**Question:** What practical steps can the firm take to increase gearing, and what might be the advantages or drawbacks?

> **Answer:**
> The company may:
>
> - Issue new debt to fund share repurchase (increasing debt relative to equity)
> - Initiate higher dividends, reducing equity via lower retained earnings
> - Use debt finance for future investments rather than equity
>   Advantages: Restoring optimal (lower-cost) capital structure, improved shareholder returns if WACC is reduced.
>   Drawbacks: Increased financial risk, stricter debt covenants, possible rating downgrades, and reduced flexibility to absorb future shocks.

## THE SIGNIFICANCE OF FINANCIAL FLEXIBILITY

Maintaining spare debt capacity enables firms to respond quickly to opportunities (e.g., acquiring a competitor) or to survive downturns. Companies may choose to under-gear (i.e., operate below the theoretical optimum) so they can borrow if needed later, especially when future investment needs are uncertain.

### **Worked Example 1.2**

A manufacturing company is concerned about possible economic shocks and a volatile order book. Its board debates whether to raise extra long-term debt now to fully utilise cheap credit, or to preserve flexibility.

**Question:** What factors should management consider regarding financial flexibility?

> **Answer:**
>
> - Benefits of an immediate debt raise: locks in low rates, optimises WACC in the short term
> - Risks: High gearing reduces options if conditions worsen, covenants restrict future actions, may increase bankruptcy risk
> - Maintaining flexibility: Leaves borrowing capacity for crises or for major investments, signals prudence to investors

## CAPITAL STRUCTURE POLICY AND INVESTOR SIGNALS

A change in capital structure, especially large equity issues, can send signals to the market—sometimes interpreted as bad news (e.g., shares are overvalued or profits are expected to fall). This is a central idea in pecking order theory.

### **Exam Warning**

> Large departures from target gearing—such as sudden, unexplained debt increases—may alarm stakeholders and trigger negative market reactions. Always relate policy changes to company fundamentals in analysis questions.

## **Summary**

Capital structure management balances theoretical models, risk and stakeholder preferences, and practical realities. Whilst theory provides a guide, real-world decisions reflect the need for flexibility, market signals, and the importance of maintaining a prudent but responsive financial base.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Traditional, Modigliani-Miller, static trade-off, and pecking order theories of capital structure
- The meaning and use of a target capital structure
- Key influences on target gearing ratios in practice
- The concept of financial flexibility and its real-world importance
- The practical steps companies use to maintain or adjust their capital structure
- The relevance of capital structure decisions for cost of capital, value, and risk

## **Key Terms and Concepts**

- capital structure
- target capital structure
- weighted average cost of capital (WACC)
- static trade-off theory
- pecking order theory
- financial flexibility

Capital structure theory and practice - Target structure and financial flexibility