## **Learning Outcomes**

This article explains the core capital structure and payout policy concepts assessed at CFA Level 2, focusing on how firms balance the benefits and costs of debt and equity. It clarifies how the trade-off theory identifies an optimal debt level by weighing tax shields against expected financial distress and agency costs, and how this optimal point affects firm value, risk, and the weighted average cost of capital. It also analyzes the pecking order theory, emphasizing the financing hierarchy from internal funds to debt to external equity and the role of information asymmetry, issue costs, and financial flexibility in shaping real-world funding choices. In addition, this article examines how capital structure decisions interact with payout policy, influencing a firm’s ability to pay dividends and repurchase shares under different debt levels. Throughout, it links theory to exam-style applications, helping you interpret scenarios, identify common exam traps, and select the most appropriate explanation of financing behavior, the optimal capital structure, and payout decisions in multiple-choice and item-set questions.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand how companies determine their capital structure and payout policy, with a focus on the following syllabus points:

- Explaining the trade-offs involved in choosing the optimal capital structure
- Evaluating the effects of debt on firm value, cost of capital, and financial risk
- Analyzing the pecking order theory and its influence on actual financing behavior
- Interpreting the practical implications of payout policy on shareholder wealth

## **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 the trade-off theory of capital structure?
   a) Firms set debt levels to maximize tax shields and minimize bankruptcy costs
   b) Firms always avoid debt due to financial distress risk
   c) Investors decide capital structure, not firms

2. According to the pecking order theory, which financing source do profitable firms prefer?
   a) External equity
   b) Debt
   c) Internal cash flows

3. If a firm's cost of debt rises above its cost of equity, what does the trade-off theory predict will happen to its optimal debt level?

4. True or false: Under the pecking order theory, firms maintain a target debt-to-equity ratio.

## **Introduction**

The decision of how much debt and equity a firm should use—its capital structure—is central to corporate finance. Choosing the right mix of funding affects company value, risk, and payout flexibility. Two essential frameworks for CFA Level 2 are the trade-off theory, which balances the benefits and costs of using debt, and the pecking order theory, which describes real-world financing choices firms make due to asymmetric information and transaction costs. Understanding both concepts is critical for evaluating firm policies on debt, dividends, and repurchases.

> **Key Term: capital structure**
> The combination of debt and equity a company uses to finance its operations and investments.
>
> **Key Term: gearing**
> The use of fixed-cost (debt) financing to increase potential returns and risk for equity holders.

## **The Optimal Capital Structure—The Trade-off Theory**

A firm's capital structure decision involves balancing the benefits and costs of debt and equity. The trade-off theory suggests there is an optimal level of debt where firm value is maximized.

### Benefits of Debt

- **Interest Tax Shield:** Debt interest is usually tax deductible, lowering a firm's tax bill and increasing after-tax cash flows.
- **Agency Benefits:** Debt can help reduce agency costs by forcing managers to return excess cash to investors instead of overinvesting.

### Costs of Debt

- **Financial Distress and Bankruptcy Costs:** High debt levels increase the risk the firm cannot meet obligations, raising the probability of costly distress (legal, administrative, loss of customers).
- **Agency Costs of Debt:** Debt can encourage risk-shifting or underinvestment by equity holders if financial distress is likely.

The optimal capital structure is reached by weighing these factors:

> **Key Term: trade-off theory**
> The hypothesis that optimal capital structure is achieved by balancing the tax benefits of debt against costs of financial distress and agency problems.

As debt increases:

- The tax shield initially increases firm value.
- The costs of distress become more relevant as debt rises.
- At some point, further increases in debt reduce firm value due to rising expected distress costs.

### **Worked Example 1.1**

A company pays a 5% interest rate on debt, and corporate tax is 25%. Management considers increasing the debt ratio from 30% to 60%. What factors should they evaluate using the trade-off theory?

> **Answer:**
>
> - At higher debt, the interest tax shield increases: more interest means more tax saved.
> - However, higher debt levels raise the probability and expected cost of financial distress (e.g., legal costs or business disruption in bankruptcy).
> - Management must compare the incremental tax benefit to the incremental expected distress cost. If distress costs rise faster than tax shields, raising debt may lower total value.

### **Exam Warning**

> Focusing only on the tax shield of debt and ignoring distress and agency costs is a frequent exam mistake. The correct answer is rarely "maximize debt for maximum tax shield." Always mention rising costs of distress and the possibility of an optimal, not maximum, level of debt.

## **The Pecking Order Theory**

While the trade-off theory suggests firms target a unique optimal debt ratio, the pecking order theory observes that many firms follow a hierarchy in financing choices:

1. Use internal funds (retained earnings) first.
2. If more funds are needed, issue debt.
3. Issue equity only as a last resort.

This framework is based on:

- **Information Asymmetry:** Managers know more about firm value than external investors. Raising equity can signal the firm is overvalued, depressing share price.
- **Issue Costs:** Equity is generally more expensive due to flotation costs and adverse price reactions.
- **Flexibility:** Firm prefers financing that minimizes outside scrutiny or dilution.

> **Key Term: pecking order theory**
> Hypothesis stating that firms prefer internal over external financing, and debt over equity, due to asymmetric information and transaction costs.

## **Capital Structure and Cost of Capital**

A firm’s weighted average cost of capital (WACC) at first decreases as more debt is introduced—due to the tax deductibility and lower cost of debt compared to equity. However, as debt increases, both debt and equity become riskier, so their costs rise. The optimal capital structure minimizes WACC and maximizes firm value.

### **Worked Example 1.2**

A company's assets are financed with 50% equity (cost: 10%) and 50% debt (cost: 6%). If the tax rate rises from 20% to 35%, how does the optimal debt ratio change?

> **Answer:**
>
> - Higher tax rates increase the tax benefit of interest.
> - With a bigger tax shield, the firm can support higher debt before distress costs outweigh benefits, so the optimal debt ratio likely increases.

## **Practical Implications: Payout Policy and Capital Structure**

Capital structure choices directly impact a firm’s payout policy. Firms with high debt commitments (interest and principal payments) often have less ability to maintain or increase dividends or repurchase shares. Conversely, firms with lower debt may have more flexibility to distribute cash.

> **Key Term: payout policy**
> The firm's approach to returning capital to shareholders, including dividends and share repurchases.
>
> **Key Term: financial flexibility**
> The firm's capacity to access funding and adjust payouts in response to investment needs and unforeseen events.

### **Worked Example 1.3**

A profitable technology company has accumulated excess cash. According to the pecking order theory, how is it most likely to fund a new expansion?

> **Answer:**
>
> - It will use internal cash first.
> - If more funds are needed, management prefers issuing debt.
> - New equity is used only if internal cash and debt capacity are inadequate.

## **Summary**

The trade-off theory explains why firms balance tax benefits and distress costs to find an optimal debt level. The pecking order theory describes observed financing choices, with a strong preference for internal capital and debt over equity due to information asymmetry and costs. Both frameworks are key for analyzing real-world capital structure and payout policy decisions.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The trade-off theory: balancing tax shields versus distress and agency costs
- The concept of an optimal capital structure for minimizing WACC and maximizing value
- The pecking order theory: firms prefer internal funds, then debt, then equity
- The impact of debt on payout policy and financial flexibility
- How information asymmetry and transaction costs impact real-world financing behavior

## **Key Terms and Concepts**

- capital structure
- gearing
- trade-off theory
- pecking order theory
- payout policy
- financial flexibility

Capital structure and payout policy - Optimal leverage trade-offs and pecking order