ACCA Applied Skills · Financial Management

Capital Structure Theories and Practical Considerations for ACCA FM

Capital structure theory asks whether the mix of debt and equity changes company value. The traditional view says an optimal gearing level exists. Modigliani and Miller say value is unaffected without tax, and rises with debt when tax relief applies. Pecking order and practical factors explain real choices.

What this chapter covers

This chapter asks one question: does the way a company finances itself change its value? You start with the cost of capital and WACC, because every theory is a claim about how WACC moves as gearing changes. If WACC falls, company value rises. If WACC stays flat, value does not change.

You then meet the theories in a logical order. The traditional view says WACC falls at first as cheap debt is added, then rises as financial risk grows, so an optimal gearing level exists. Modigliani and Miller (M&M) without taxes say gearing has no effect on value. M&M with corporate tax say debt adds value through the tax shield. Pecking order theory moves from value to behaviour: managers prefer retained earnings first, then debt, then new equity.

The chapter ends with practical factors such as business risk, security, cash flow stability, covenants, issue costs and tax position. It links to the rest of the paper in several places: cost of equity and the CAPM, cost of debt, investment appraisal using WACC, and the sources of finance chapters. It also feeds the business valuation work, where the discount rate depends on the capital structure.

This chapter gives you marks in both parts of the exam. In the objective sections, you may be asked which statement about a theory is correct, or how WACC or value changes when gearing changes. These are all-or-nothing questions, so a precise knowledge of each theory's assumptions pays off. In the constructed response section, you can be asked to discuss whether a company should change its gearing. A strong answer ties theory to the scenario with practical factors. The theory is short and the ideas repeat, so the effort needed is small compared with the marks available.

Capital structure theories and practical considerations: topics in the order to study them

1Cost of Capital and WACC RecapEvery theory is a statement about how WACC and value move with gearing, so you need the cost of equity, cost of debt and weighting right first.
2Traditional View of Capital StructureIt is the most intuitive theory: a U-shaped WACC curve with an optimal gearing level. It sets the baseline the later theories challenge.
3Modigliani and Miller Without TaxesThis is the sharpest contrast with the traditional view. It introduces the assumptions and the idea that the cost of equity rises to offset cheaper debt.
4Modigliani and Miller With Corporate TaxIt builds directly on the no-tax case by adding the tax shield. You need the no-tax result clear before this one makes sense.
5Pecking Order TheoryIt shifts from theory about value to how managers actually choose finance. It is easier once you know what the earlier theories predict.
6Practical Factors Affecting Gearing DecisionsIt pulls everything together. You use these factors to criticise the theories and to write scenario answers, so it comes last.

How to prepare Capital structure theories and practical considerations

Treat this chapter as a short set of ideas to compare, plus a few calculations. Aim to be able to state each theory in one sentence and apply it to a scenario.

Revise the WACC formula: WACC = [E ÷ (E + D)] × Ke + [D ÷ (E + D)] × Kd × (1 − t). Practise with market values, not book values.
Draw the WACC curve for the traditional view and label the optimal point. Then draw the M&M no-tax and with-tax versions beside it. Seeing the three shapes together is the best memory aid.
Write down the assumptions of M&M (perfect capital markets, no tax in the basic version, no bankruptcy costs, risk-free borrowing at the same rate for all). Practise saying which assumption fails in practice.
Learn the M&M with-tax effect: debt adds value equal to the tax shield, so value of the geared company = value of the ungeared company + tax rate × debt (when debt is permanent). Practise a short calculation.
Learn the pecking order as a sequence, and know why managers follow it: cost, control and signalling to the market.
Write a short scenario answer on whether a company should raise gearing. Use two or three practical factors from the scenario, and link each to a theory.
Finish with objective practice. Check why each wrong option is wrong, as these questions are marked all or nothing.

Common mistakes in Capital structure theories and practical considerations

Mixing up the three theories' WACC shapes.
Fix: Draw all three on one set of axes: U-shaped for traditional, flat for M&M without tax, falling for M&M with tax. Practise the sketch from memory.
Saying M&M without tax means debt is free or has no effect on anything.
Fix: State the full logic: cheaper debt is exactly offset by a higher cost of equity, so WACC stays the same.
Ignoring the assumptions behind M&M.
Fix: Learn the key assumptions and be ready to say which ones fail in practice, such as no bankruptcy costs and equal borrowing rates.
Using book values or pre-tax debt cost in WACC.
Fix: Use market values and multiply the cost of debt by (1 − t) when interest is tax-deductible.
Treating pecking order as a theory of optimal gearing.
Fix: Describe it as a description of financing preferences driven by cost, control and signalling.
Writing a theory essay instead of an answer to the scenario.
Fix: Pick the facts in the scenario, such as unstable profits or lack of security, and state what each means for the gearing decision.

Last-day revision: Capital structure theories and practical considerations

WACC is weighted using market values of equity and debt, with debt cost taken after tax.
Traditional view: WACC falls as cheap debt is added, then rises as financial risk grows; there is an optimal gearing level.
M&M without tax: value and WACC are unaffected by gearing.
M&M without tax: the cost of equity rises linearly with gearing, which offsets the cheaper debt.
M&M with tax: debt gives a tax shield, so WACC falls and value rises as gearing increases.
M&M with tax and permanent debt: value geared = value ungeared + tax rate × debt.
M&M theory in its pure form implies near 100% debt, which ignores bankruptcy costs and other real-world limits.
Pecking order: retained earnings first, then debt, then new equity.
Pecking order is about managers' preferences, not about finding an optimal gearing level.
Practical factors: business risk, cash flow stability, security available, covenants, issue costs, tax position and the company's existing gearing.
Financial risk is the extra variability in returns to shareholders caused by fixed interest payments.
In written answers, link each point to the scenario instead of listing theory.

Capital structure theories and practical considerations practice questions

Capital structure theories and practical considerations in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital structure theories and practical considerations: frequently asked questions

What is the difference between the traditional view and Modigliani and Miller?

The traditional view says an optimal gearing level exists where WACC is lowest and value is highest. M&M without tax say gearing does not affect WACC or value. M&M with tax say more debt raises value because of the tax shield.

Why does the cost of equity rise in M&M without tax?

Shareholders face more financial risk as gearing rises, so they demand a higher return. In M&M, this rise exactly offsets the benefit of cheaper debt, which leaves WACC unchanged.

If M&M with tax says debt adds value, why do companies not use almost all debt?

In practice there are bankruptcy and distress costs, agency costs, limited security and lender covenants. Companies also need spare borrowing capacity and may have no taxable profit to use the tax shield.

How should I answer a written question on a company's gearing decision?

Start with the company's current position, then use the theories briefly to explain the likely effects of change. Spend most of your answer on practical factors drawn from the scenario, and end with a clear recommendation.