## **Learning Outcomes**

After reading this article, you will be able to explain the concept of financial gearing, distinguish between operating and financial risk, and understand how beta measures systematic risk related to capital structure. You will learn and compare the traditional view and Modigliani-Miller (MM) theories (with and without tax) on capital structure, and apply beta adjustments for gearing in project appraisal—key skills for the ACCA FM exam.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand how capital structure affects company value and cost of capital. In particular, you should be comfortable with:

- Defining and calculating financial and operating gearing, as well as interest cover ratios
- Explaining the impact of gearing on business and financial risk
- Understanding and applying the concept of beta and its adjustment for financial structure
- Describing and contrasting the traditional view of capital structure and the Modigliani-Miller (MM) propositions, both with and without tax
- Recognising the assumptions, limitations, and practical implications of capital structure theories, including agency costs and bankruptcy risk
- Applying MM and beta concepts to scenarios typical of ACCA FM exam questions

## **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 of the following best describes financial gearing?
   a) The proportion of variable to fixed operating costs  
   b) The proportion of debt to equity in the capital structure  
   c) The diversity of investment projects  
   d) The number of shares issued

2. According to Modigliani-Miller (without tax), what is the effect of increasing gearing on a company's weighted average cost of capital (WACC)?
   a) WACC falls  
   b) WACC rises  
   c) WACC stays the same  
   d) The effect is unpredictable

3. State the main difference between Modigliani-Miller’s propositions with and without corporate tax.

4. If a firm increases its debt in capital structure, what happens to the equity beta, assuming business risk does not change?

## **Introduction**

Understanding how a firm's financing decisions influence its value and risk is essential for effective financial management and ACCA FM exam success. This article covers key financial structure concepts—gearing, beta, and capital structure theories, with special focus on the Modigliani-Miller (MM) propositions. You’ll learn how changes in debt and equity affect company risk, required returns, and ultimately shareholder wealth.

> **Key Term: financial gearing**
> The proportion of debt finance to equity in a firm's capital structure, indicating the level of financial risk borne by shareholders.

## **GEARING AND RISK**

Gearing measures the extent to which a firm uses debt financing. There are two related concepts:

### Operating vs Financial Gearing

- **Operating gearing:** The ratio of fixed to variable operating costs; high operating gearing leads to greater sensitivity of operating profit to changes in revenue.
- **Financial gearing:** The proportion of debt (and preference shares, if treated as fixed obligations) compared with equity. High financial gearing increases the volatility of returns to shareholders.

> **Key Term: operating gearing**
> The degree to which a firm’s operating costs are fixed, relative to variable costs.
>
> **Key Term: financial risk**
> The risk to equity holders arising from the use of debt, due to the obligation to pay interest and principal regardless of performance.

### Gearing’s Impact on Shareholder Risk

An increase in financial gearing means a greater share of profits must first go to servicing debt before anything is available for equity shareholders. This increases the variability (risk) of returns to shareholders but may reduce the overall cost of capital due to the lower cost of debt compared to equity.

## **BETA AND CAPITAL STRUCTURE**

Equity investors require compensation for the risk they bear. In the Capital Asset Pricing Model (CAPM), this risk is quantified as beta (β):

> **Key Term: beta (β)**
> A measure of a security's systematic risk—how sensitive its returns are to changes in the overall market. Equity beta measures both business risk and the additional financial risk due to gearing.

When a company increases its debt, the financial risk to shareholders rises, and so does the equity beta. To compare projects or companies with different gearing, we need the asset beta:

> **Key Term: asset beta**
> The measure of business risk alone, before adjusting for the additional risk from financing (gearing).
>
> **Key Term: equity beta**
> The measure of risk borne by equity holders, reflecting both business and financial (gearing) risk.

### Adjusting Beta for Gearing

To compare investments on a like-for-like basis, we can:

1. **De-gear** the equity beta of a company in an industry to find the asset beta.
2. **Re-gear** the asset beta to reflect the target company’s capital structure.

The (simplified) formula:

$$
\beta_{\text{asset}} = \beta_{\text{equity}} \times \left( \frac{E}{E + D(1-T)} \right)
$$

Where E = market value of equity, D = market value of debt, T = corporate tax rate.

### **Worked Example 1.1**

**A company has an equity beta of 1.5 and a capital structure of \$60m equity and \$30m debt. The corporate tax rate is 30%. Find the asset beta.**

> **Answer:**

$$
\beta_{\text{asset}} = 1.5 \times \frac{60}{60 + 30 \times (1 - 0.3)} = 1.5 \times \frac{60}{60 + 21} = 1.5 \times \frac{60}{81} = 1.11
$$

## **CAPITAL STRUCTURE THEORIES**

Understanding the relationship between capital structure, company value, and cost of capital is tested in ACCA FM. Two main theories dominate:

### The Traditional View

This view suggests that, at low to moderate levels of gearing, introducing debt reduces WACC because debt is cheaper than equity. However, beyond a certain point, further increases in gearing raise the financial risk, causing the required return on equity to rise sharply—offsetting the benefit of cheap debt and increasing WACC. There is an "optimal" capital structure where WACC is minimized and company value is maximized.

### Modigliani-Miller Propositions (MM)

#### MM WITHOUT TAX (1958)

Modigliani and Miller argued that in a perfect, tax-free world with rational investors and no transaction costs:

- The choice between debt and equity does not affect the overall company value (sum of equity and debt).
- Any benefit from cheaper debt is exactly offset by an increase in the required return on equity as gearing rises.
- WACC remains unchanged as gearing increases.

> **Key Term: Modigliani-Miller proposition (no tax)**
> In a perfect, tax-free market, capital structure choices have no effect on a company’s value or WACC.

#### MM WITH CORPORATE TAX (1963)

When acknowledging that interest on debt is tax-deductible, MM revised their theory:

- Debt finance now provides a "tax shield," lowering the after-tax cost of debt and thus reducing WACC as gearing increases.
- The higher the gearing, the greater the value of the company (in theory, optimal at almost 100% debt).

> **Key Term: Modigliani-Miller proposition (with tax)**
> With corporate tax, higher gearing reduces WACC due to the tax shield on interest, thereby increasing company value.

### **Worked Example 1.2**

**A firm can be financed solely by equity or by a mix of \$1m debt (at 8% interest) and equity. Corporate tax is 30%. Illustrate the MM with-tax effect on company value (assume the same operating profit in both cases).**

> **Answer:**  
> The value of a geared firm (Vg) exceeds that of an all-equity firm (Vu) by the present value of tax savings on debt:
>
> $$
> V_g = V_u + (D \times T) = V_u + (1,000,000 \times 0.3) = V_u + 300,000
> $$
>
> Thus, using debt increases overall value by \$300,000 due to tax relief, all else being equal.

### **Exam Warning**

> Under MM with tax, the theory says firms should maximize debt, but in practice, very high gearing is rare due to bankruptcy risk, agency costs, and practical constraints. You must discuss real-world limitations in the exam.

## **REAL-WORLD LIMITATIONS AND AGENCY ISSUES**

In reality, few companies use extremely high levels of debt. Reasons include:

- Bankruptcy risk: Higher likelihood of default increases the required returns for both debt and equity, raising WACC beyond a certain point.
- Agency costs and lender restrictions: Lenders may impose covenants that restrict dividends, further borrowing, or asset sales.
- Tax exhaustion: The tax shield benefit only applies while the company is profitable enough to utilise interest deductions.
- Asset security: Limited assets may restrict additional borrowing.

> **Key Term: agency costs**
> The additional costs arising when lenders impose controls on management to protect their interests, especially at higher gearing.

### Pecking Order Theory

Some firms prefer to finance new investments using internal funds first, then debt, and only issue new equity as a last resort. This real-world preference can be due to issue costs, asymmetric information, or market signalling concerns.

> **Key Term: pecking order theory**
> A theory that firms finance growth by using internal funds first, then debt, and new equity as a last resort, rather than seeking an optimal gearing level.

## **Summary Table: Capital Structure Theories**

| Theory           | Gearing Effect on WACC       | Optimal Gearing Level        |
| ---------------- | ---------------------------- | ---------------------------- |
| Traditional View | U-shaped; minimum at optimum | Moderate (balance)           |
| MM No Tax        | WACC unchanged (flat)        | Any (irrelevant)             |
| MM With Tax      | WACC falls as debt increases | Highest possible (in theory) |

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and measure financial and operating gearing
- Describe beta, and explain how gearing affects equity beta
- Distinguish between the traditional and MM capital structure theories (with and without tax)
- Recognize the real-world limitations and the role of agency and bankruptcy costs
- Adjust beta for capital structure changes in project appraisal
- Understand pecking order theory as an alternative view of financing preference

## **Key Terms and Concepts**

- financial gearing
- operating gearing
- financial risk
- beta (β)
- asset beta
- equity beta
- Modigliani-Miller proposition (no tax)
- Modigliani-Miller proposition (with tax)
- agency costs
- pecking order theory

Gearing, beta, and structure theories - MM propositions with and without tax