Capital structure and payout - Leverage and capital structur...

Learning Outcomes

This article explains how gearing and capital structure choices affect firm value, risk, and the cost of capital within the CFA Level 1 curriculum context. It defines gearing and financial gearing, contrasts debt and equity financing, and relates these choices to changes in return on equity, financial risk, and insolvency risk. It explains how to compute and interpret key measures such as gearing ratios and the weighted-average cost of capital (WACC), linking numerical results to valuation and capital budgeting decisions. The article examines core capital structure theories, including Modigliani–Miller propositions with and without taxes, the tax shield of debt, and the trade-off between tax benefits and expected costs of financial distress. It also discusses optimal and target capital structures, pecking order theory, and agency considerations that influence real-world financing policies. Throughout, the material highlights typical CFA exam question styles, integrating conceptual explanation with calculation-based examples that train you to justify capital structure recommendations and assess how changes in gearing influence WACC and firm value.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand theories of capital structure and gearing, their impact on firm value and the cost of capital, and practical considerations in real companies, with a focus on the following syllabus points:

• Define gearing, explain its effects on return and risk, and calculate gearing ratios.
• Compare how business models and corporate life cycles influence capital structure.
• Calculate and interpret the weighted-average cost of capital (WACC).
• Describe the Modigliani–Miller propositions (with and without taxes) and their implications.
• Discuss the trade-off between the benefits and costs of debt, including financial distress.
• Explain the concept of optimal and target capital structures.
• Outline the pecking order theory and agency costs as they pertain to financing decisions.

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. According to Modigliani–Miller Proposition I in a world with no taxes or distress costs, if a firm increases its debt-to-equity ratio:
   1. Its WACC falls and firm value rises.
   2. Its WACC rises and firm value falls.
   3. Its WACC and firm value are unchanged.
   4. Its cost of equity falls and firm value rises.
2. In practice, issuing additional debt is most likely to reduce a firm’s WACC and increase firm value when:
   1. Interest is tax-deductible and expected distress costs are still low.
   2. Interest is not tax-deductible but the firm already has high gearing.
   3. The firm’s business risk and operating gearing are both very high.
   4. Existing debtholders impose tight covenants limiting further borrowing.
3. A main real-world reason why most firms avoid extremely high (near 100%) debt financing is that:
   1. Equity is always cheaper than debt.
   2. Expected costs of financial distress rise as gearing becomes very high.
   3. Tax authorities limit the tax deductibility of interest at any gearing level.
   4. Using only debt prevents managers from overinvesting.
4. According to the pecking order theory, a highly profitable firm is most likely to avoid issuing new equity because:
   1. Equity issuance reduces the firm’s tax shield.
   2. Equity issuance signals that the firm is overvalued due to information asymmetry.
   3. Equity is always more expensive than debt in all circumstances.
   4. Equity issuance violates debt covenants in most loan agreements.

Introduction

Gearing and capital structure choices are a core part of corporate finance and directly affect risk, return, and firm value. This article examines gearing, the theories around optimal capital structure, and the practical forces influencing firms’ financing decisions. You will learn how debt and equity affect costs, understand key theoretical frameworks, and develop the ability to apply these ideas to CFA-style exam questions.

Key Term: Gearing
Gearing (also called financial gearing) is the use of fixed financial obligations—such as interest from debt financing or lease payments—to magnify potential returns and risks to equity holders.

Key Term: Capital Structure
Capital structure is the mix of debt, equity, and other long-term funding that a company uses to finance its assets and operations.

Key Term: Weighted-Average Cost of Capital (WACC)
WACC is the blended required rate of return across all sources of long-term capital, weighting each component (debt and equity) by its proportion of the firm’s total value.

At Level 1, you are expected to understand not only how to compute these quantities but also how changes in gearing affect shareholder returns, financial risk, and overall firm value.

Gearing and Capital Structure: Concepts

Gearing refers to the use of borrowed funds (debt) or obligations (such as leases) to increase the potential return or risk to equity holders. Increasing gearing raises both the upside and the downside variability of earnings to shareholders.

Capital structure describes the combination—by value—of debt, equity, and sometimes other securities, that a firm uses to finance its overall operations. Each component has an associated required rate of return determined by market participants.

Key Term: Financial Gearing
Financial gearing is the use of debt or other fixed financial obligations that increases the volatility of net income and return on equity for shareholders.

Business Risk vs Financial Risk

The total risk borne by equity investors arises from two sources:

• Business risk: Uncertainty in operating income (EBIT) due to the firm’s industry, competitive position, and operating cost structure.
• Financial risk: Additional variability in net income and return on equity caused by financing choices, particularly the use of debt.

Key Term: Business Risk
Business risk is the uncertainty associated with operating income due to factors such as demand variability, input costs, and operating gearing.

Key Term: Financial Risk
Financial risk is the additional risk to equity holders arising from the use of debt and other fixed financing obligations in the firm’s capital structure.

Even if two firms have identical business risk, the one with higher gearing will show more volatile earnings per share and return on equity because interest payments must be made regardless of the business cycle.

Operating Gearing and Financial Gearing

Operating gearing and financial gearing interact to determine the overall volatility of equity returns.

Key Term: Operating Gearing
Operating gearing is the extent to which a firm’s cost structure contains fixed operating costs. Higher operating gearing means profits are more sensitive to changes in sales.

A firm with high operating gearing (many fixed costs) will see operating income change by a greater percentage than sales. If such a firm also takes on high financial gearing, the combined effect can make net income extremely sensitive to sales downturns.

Key Term: Degree of Financial Gearing (DFL)
The degree of financial gearing is the sensitivity of net income to changes in operating income, calculated as the percentage change in net income divided by the percentage change in operating income.

High DFL indicates that relatively small percentage changes in operating income lead to larger percentage changes in net income, highlighting the risk borne by equity holders when debt levels are high.

Key Term: Interest Coverage Ratio
The interest coverage ratio equals EBIT divided by interest expense. It measures the firm’s ability to meet interest payments from operating profits.

Lower interest coverage indicates higher financial risk and typically leads investors to demand higher required returns on both debt and equity.

Impact of Gearing

Higher gearing increases expected return on equity in favorable conditions but also increases risk, including insolvency and bankruptcy risk in adverse circumstances. The firm’s business risk, combined with financial risk, determines total risk to shareholders.

Consider two firms with identical assets and operating income but different capital structures. The more highly levered firm will generally show:

• Higher return on equity in good years (because profits are spread over less equity).
• Lower interest coverage and higher probability of financial distress in bad years.
• A wider range of possible outcomes for equity investors.

This trade-off between higher expected return and higher risk is central to capital structure analysis and appears frequently in Level 1 item sets.

Cost of Capital and Structure

The weighted-average cost of capital (WACC) is the rate a firm must earn on its assets to satisfy both debt and equity investors. It serves as the discount rate for evaluating average-risk projects and for valuing the firm’s free cash flows.

Debt is usually less costly than equity because:

• Debt holders have priority over equity holders in cash flows and liquidation.
• Interest payments are often tax-deductible, creating a tax advantage.

WACC is calculated as:

where:

• $w_d$ and $w_e$ are the target or market-value weights of debt and equity,
• $r_d$ is the pre-tax cost of debt,
• $r_e$ is the cost of equity, and
• $T$ is the corporate tax rate.

Key Term: Levered Firm
A levered firm is a company that finances itself with some combination of debt and equity.

Key Term: Unlevered Firm
An unlevered firm is a hypothetical company financed entirely with equity and no debt.

Using Target vs Current Capital Structure

In WACC calculations, analysts often prefer to use target capital structure weights rather than current market weights, especially if management has an explicit financing policy.

Key Term: Target Capital Structure
Target capital structure is the mix of debt and equity that management aims to maintain over the long run.

Reasons to use target weights include:

• Market values of equity can fluctuate significantly and may not reflect sustainable gearing.
• Lenders and rating agencies often measure gearing using book values.
• Management’s decisions on future capital raising are guided by target ranges, not by today’s exact market ratios.

When a firm has a stated target such as “40% debt, 60% equity,” you should generally use these weights when computing WACC for capital budgeting questions.

Worked Example 1.1

A company has 40% debt (pre-tax cost 5%) and 60% equity (cost 10%). The tax rate is 25%. What is its WACC?

Answer:
$\text{WACC} = 0.4 \times 0.05 \times (1-0.25) + 0.6 \times 0.10 = 0.4 \times 0.0375 + 0.06 = 0.015 + 0.06 = 0.075$ or 7.5%.
Interpretation: The firm must earn at least 7.5% on its invested capital to satisfy both debtholders and equity investors.

Worked Example 1.2

Suppose the same firm decides to move to a target capital structure of 50% debt and 50% equity. The cost of debt remains 5% (pre-tax), but the cost of equity rises to 11% due to higher financial risk. The tax rate is still 25%. What is the new WACC?

Answer:
$\text{WACC} = 0.5 \times 0.05 \times (1-0.25) + 0.5 \times 0.11$
$= 0.5 \times 0.0375 + 0.055 = 0.01875 + 0.055 = 0.07375$ or 7.375%.
Even though equity became more expensive, the greater weight of tax-advantaged debt slightly reduced WACC.

In practice, as gearing rises, the cost of equity and eventually the cost of debt will both increase to compensate for higher risk. Whether WACC falls, stays the same, or rises depends on how these effects balance—this is where capital structure theories such as Modigliani–Miller become important.

Capital Structure Theories

Modigliani–Miller (MM) Propositions: No Taxes

The Modigliani–Miller theory provided two foundational propositions about capital structure under a highly simplified set of assumptions.

Key Term: Modigliani–Miller Assumptions
MM’s basic model assumes no taxes, no transaction or bankruptcy costs, symmetric information, fixed investment policy, and that investors can borrow and lend at the risk-free rate.

Under these assumptions, capital markets are “perfect,” and financing choices do not change the fundamental economic value of the firm’s assets.

Key Term: MM Proposition I (No Taxes)
In a world without taxes or transaction costs, capital structure is irrelevant: firm value is determined solely by the present value of its expected future cash flows, not by the mix of debt and equity.

Formally, the value of a levered firm equals the value of an otherwise identical unlevered firm:

Key Term: Homemade Gearing
Homemade gearing is the idea that investors can replicate any desired gearing by borrowing or lending on their own, independent of the firm’s capital structure.

If an investor wants more gearing than the firm uses, they can borrow personally and buy more shares; if they want less gearing, they can lend part of their wealth. Because investors can undo the firm’s financing decisions, capital structure does not affect overall investor wealth under MM’s assumptions.

Key Term: MM Proposition II (No Taxes)
With no taxes, the cost of equity increases linearly with the debt-to-equity ratio, offsetting the cheaper cost of debt so that WACC and firm value remain unchanged.

Mathematically:

where:

• $r_e$ is the cost of equity,
• $r_0$ is the cost of capital for an unlevered firm,
• $r_d$ is the cost of debt, and
• $D/E$ is the debt-to-equity ratio (using market values).

As the firm adds more lower-cost debt, the risk to equity holders increases, so the required return on equity rises exactly enough to keep WACC constant.

Worked Example 1.3

An unlevered firm has a cost of capital $r_0 = 10\%$. It is considering moving to a capital structure with a debt-to-equity ratio $D/E = 0.5$. The cost of debt is 6%, and there are no taxes. What is the new cost of equity according to MM Proposition II (no taxes)?

Answer:
Use $r_e = r_0 + (r_0 - r_d)\frac{D}{E}$.
$r_e = 10\% + (10\% - 6\%) \times 0.5 = 10\% + 4\% \times 0.5 = 10\% + 2\% = 12\%$.
Although the firm introduces cheaper debt, the cost of equity rises to 12%, and overall WACC remains 10%.

MM Theory with Corporate Taxes

In reality, most tax systems allow firms to deduct interest from taxable income, but not dividends. This creates a tax shield from debt.

Key Term: Tax Shield
The tax shield is the reduction in income taxes resulting from deducting interest expense, which increases firm value as debt rises (up to a point).

With corporate taxes, MM show that the value of a levered firm equals the value of an unlevered firm plus the present value of the tax shield:

where $T$ is the corporate tax rate and $D$ is the market value of debt (assuming permanent debt).

Because debt provides a tax benefit, WACC declines as gearing increases:

and the cost of equity with taxes becomes:

The factor $(1-T)$ reduces the slope of the increase in $r_e$ with gearing because taxes partly offset the risk of debt.

Key Term: Cost of Financial Distress
The cost of financial distress is the present value of expected bankruptcy and distress-related costs, including legal fees, asset fire-sale losses, loss of customers or suppliers, and management distraction.

In MM’s model with taxes but without distress costs, firms would want 100% debt financing because each additional unit of debt adds tax shield value, and there are no offsetting costs. Real-world evidence, however, shows that most firms use moderate rather than extreme gearing, which leads to the trade-off theory.

Worked Example 1.4

A firm has perpetual EBIT of $2 million and its all-equity value is $16 million. The corporate tax rate is 25%. If it borrows $4 million, what is the new firm value under MM with taxes, assuming no distress costs?

Answer:
Tax shield value = $T \cdot D = 0.25 \times 4$ million = $1 million.
Levered firm value V_L = V_U + T \cdot D = 16 + 1 = \17 million. Leveraging increases firm value by \1 million in this simplified setting.

Trade-Off and Optimal Capital Structure

Real firms face a trade-off. More debt initially reduces WACC due to the tax shield, but at higher levels, rising financial distress costs increase WACC and reduce value.

Key Term: Static Trade-Off Theory
Static trade-off theory states that a firm chooses its capital structure by balancing the tax benefits of additional debt against the increase in the present value of expected financial distress costs.

The value of a levered firm can be written as:

Initially, as debt rises from zero, the incremental tax shield is large relative to expected distress costs, so firm value increases and WACC falls. Beyond some point $D^\*$, additional debt increases expected distress costs more than it adds tax shield value, so firm value declines.

Key Term: Optimal Capital Structure
Optimal capital structure is the mix of debt and equity that maximizes firm value (or equivalently minimizes WACC), balancing tax benefits of debt against expected costs of financial distress.

In practice, managers cannot pinpoint $D^\*$ precisely. Instead, they select a target range for gearing (for example, 30%–50% debt to total capital) that reflects:

• Business risk and earnings volatility.
• Asset tangibility (quality of collateral).
• Desire to maintain a certain credit rating and access to capital markets.
• Industry norms and regulatory constraints.

Worked Example 1.5

Continuing from Worked Example 1.4, assume the present value of expected distress costs at $4 million of debt is $0.5 million. What is the net value benefit from using $4 million of debt?

Answer:
Tax shield = $1.0 million.
PV of distress costs = $0.5 million.
Net benefit of gearing = 1.0 − 0.5 = $0.5 million.
Levered firm value V_L = 16 + 0.5 = \16.5 million. Compared to the no-distress-cost case, the optimal debt level may be lower than \4 million if distress costs rise rapidly beyond this point.

Agency Costs and Capital Structure

Capital structure decisions are also influenced by agency costs—costs arising from conflicts of interest among stakeholders.

Key Term: Agency Costs
Agency costs are costs that arise when managers, shareholders, and debtholders have conflicting objectives, leading to value-reducing actions or the need for monitoring and incentive mechanisms.

Key agency issues include:

• Manager–shareholder conflicts: Managers may prefer empire-building or perquisite consumption rather than maximizing shareholder value. Debt can reduce free cash flow available for wasteful spending, thus disciplining management. However, too much debt can induce excessive risk-taking.
• Shareholder–debtholder conflicts: Highly levered equity holders may undertake very risky projects (asset substitution) because they capture upside while debtholders bear much of the downside. Debtholders respond by demanding higher interest rates or restrictive covenants.

These agency considerations help explain why capital structure is not determined solely by tax and distress trade-offs.

Pecking Order Theory

Firms may borrow less than the trade-off theory predicts due to agency costs or because of asymmetric information between managers and outside investors.

Key Term: Information Asymmetry
Information asymmetry arises when managers know more about the firm’s true value and risk than outside investors.

Key Term: Pecking Order Theory
Pecking order theory states that firms prefer to finance new investments using internal funds first, then debt, and issue new equity only as a last resort.

The logic is:

• Managers fear that issuing new equity when they have better information than investors may signal that the firm’s shares are overvalued, leading to a drop in share price.
• Using retained earnings does not send such a negative signal and does not incur flotation costs.
• If external financing is needed, debt is preferred to equity because it is less sensitive to mispricing and may be cheaper.

A key implication is that more profitable firms may have less debt, not more, because they can fund projects internally—this is the opposite of what static trade-off theory might suggest.

Practical Considerations in Capital Structure

In reality, capital structure decisions depend on a variety of firm-specific and external factors beyond simple theoretical models.

Business Model and Asset Structure

• Capital-intensive firms (e.g., utilities, airlines, heavy manufacturing) have large investments in tangible fixed assets that can serve as collateral. They often support higher debt levels.
• Capital-light firms (e.g., software, platform businesses) hold fewer tangible assets, rely heavily on intangibles and human capital, and may have less access to secured debt.

Key Term: Capital-Intensive Business
A capital-intensive business requires large investments in physical assets relative to sales and typically has high fixed costs and financing needs.

Key Term: Capital-Light Business
A capital-light business operates with relatively low investment in physical assets, often relying on networks, intangibles, or contractual arrangements, and may need less external financing.

Leases and secured borrowing allow firms to use specific assets as collateral, lowering the cost of debt. At the same time, assets that are highly specialized or illiquid provide less support for gearing.

Corporate Life Cycle and Capital Structure

Capital structure typically evolves over a firm’s life cycle:

Key Term: Corporate Life Cycle
The corporate life cycle describes stages of a firm’s development—startup, growth, and mature—each with characteristic cash flows and financing choices.

• Startup phase: Revenues are low or negative; business risk is high; free cash flow is usually negative. Debt availability is limited, often to leases or convertible debt. Equity financing comes mainly from founders, employees, and venture capital investors.
• Growth phase: Revenue grows rapidly but large investments are needed for expansion. Free cash flow may still be negative but visibility improves. Some secured debt becomes available, but equity usually dominates financing.
• Mature phase: Revenue growth slows but becomes more predictable; free cash flow turns positive and stable. The firm can borrow more cheaply (often unsecured) and commonly uses significant debt, while also paying dividends or repurchasing shares.

Life-cycle considerations help explain why an early-stage technology company may have almost no debt, whereas a mature utility may have high but stable gearing.

Business Risk, Operating Gearing, and Cyclicality

Firms with stable revenues and low operating gearing (more variable costs) can support higher financial gearing, because operating income is less volatile. Conversely:

• High operating gearing magnifies the effect of sales changes on operating income, making profits more cyclical.
• Combining high operating and financial gearing can be dangerous in economic downturns.

Investors therefore demand a higher cost of capital for firms with high business risk and high operating gearing, limiting the amount of value-enhancing debt such firms can use.

Regulation, Taxes, and Market Conditions

• Regulated industries (e.g., banks, utilities) often face capital adequacy rules or rate regulation that effectively constrain gearing.
• Tax regimes determine the size of the interest tax shield. If interest deductibility is limited, the attractiveness of debt declines.
• Capital market conditions influence timing: when interest rates are low, firms may issue more debt; when equity markets are strong, equity issuance may be preferred.

Because market values change over time, even firms with a stable financing policy will see their observed debt-to-equity ratios fluctuate. This is one reason firms usually specify a target range for gearing rather than a single number.

Target Capital Structure in Practice

Managers consider both internal and external constraints when setting target capital structures, including:

• Maintaining an investment-grade credit rating.
• Avoiding violation of debt covenants.
• Preserving financial flexibility to fund acquisitions or weather downturns.
• Aligning with industry norms to avoid appearing too risky or too conservative.

Capital structure is therefore best viewed as a strategic policy variable that supports the firm’s long-term business model and risk management, rather than as an isolated formula outcome.

Summary

Capital structure decisions directly impact risk, return, and firm value. While Modigliani–Miller theory shows that, under extreme assumptions, capital structure is irrelevant without taxes or distress, real-world features—such as the tax shield from interest, bankruptcy risk, agency costs, and information asymmetries—make financing choices important.

Moderate debt can lower WACC and increase firm value by exploiting tax benefits and disciplining management. However, excessive gearing raises the expected costs of financial distress and can harm both debtholders and shareholders. The optimal capital structure balances these forces and is implemented in practice as a target range that reflects business risk, asset characteristics, life-cycle stage, and market conditions.

For the CFA Level 1 exam, you should be comfortable:

• Computing and interpreting WACC for different capital structures.
• Explaining MM propositions with and without taxes.
• Describing the trade-off and pecking order theories and their implications.
• Linking changes in gearing to firm value, financial risk, and capital budgeting decisions.

Key Point Checklist

This article has covered the following key knowledge points:

• Define gearing and capital structure and explain their effect on risk and return.
• Distinguish between business risk, operating gearing, and financial risk.
• Calculate and interpret WACC for various combinations of debt and equity, using target capital structure where appropriate.
• State the Modigliani–Miller propositions with and without taxes and explain their implications for cost of capital and firm value.
• Explain the tax shield of debt and how it increases with gearing, but discuss the rising cost of financial distress at high gearing levels.
• Describe the static trade-off theory and optimal capital structure as the point where marginal tax benefits equal marginal distress costs.
• Recognize the role of agency costs in capital structure choice and how debt and covenants can mitigate or create conflicts.
• Outline pecking order theory and explain why profitable firms may rely more on internal financing and less on new equity.
• Discuss how business models, asset structures, industry regulation, and corporate life cycles influence capital structure in practice.

Key Terms and Concepts

• Gearing
• Capital Structure
• Weighted-Average Cost of Capital (WACC)
• Financial Gearing
• Business Risk
• Financial Risk
• Operating Gearing
• Degree of Financial Gearing (DFL)
• Interest Coverage Ratio
• Levered Firm
• Unlevered Firm
• Target Capital Structure
• Modigliani–Miller Assumptions
• MM Proposition I (No Taxes)
• Homemade Gearing
• MM Proposition II (No Taxes)
• Tax Shield
• Cost of Financial Distress
• Static Trade-Off Theory
• Optimal Capital Structure
• Agency Costs
• Information Asymmetry
• Pecking Order Theory
• Capital-Intensive Business
• Capital-Light Business
• Corporate Life Cycle