Financial Management · Capital structure theories and practical considerations

Practical Factors Affecting Gearing Decisions in ACCA Financial Management

Updated 11 October 2026 · Fact-checked

Practical gearing factors are real-world reasons why a firm cannot simply borrow more to cut its cost of capital. They include bankruptcy costs, agency costs, tax exhaustion, asset security, debt capacity, and cash flow stability. They explain why Modigliani and Miller's theory is limited and why firms stop short of very high gearing.

Understand Practical Factors Affecting Gearing Decisions

Modigliani and Miller (with tax) say debt is valuable because interest is tax deductible. Followed to the end, that suggests a firm should use almost all debt. Real firms do not. The reason is that the theory rests on assumptions that do not hold in practice.

The main assumptions that fail are: no bankruptcy or distress costs, no agency costs, perfect capital markets where firms and investors borrow at the same risk-free rate, and enough taxable profit to use all the tax relief. Each failure gives you a practical factor to discuss.

Bankruptcy and distress costs. As gearing rises, the chance of failing to pay interest rises. Costs of failure include legal and administrator fees, forced asset sales at low prices, lost customers, lost suppliers' trust and key staff leaving. Investors price this in. Equity holders demand a higher return and lenders charge more interest. Past some level of gearing, these costs outweigh the tax benefit.

Agency costs. Lenders worry that managers or shareholders will act against their interests, for example by taking on risky projects or paying large dividends. So lenders add restrictive covenants, such as limits on further borrowing, dividends or asset sales. These cut management's freedom and have a cost. Lenders also charge more interest as risk rises.

Tax exhaustion. Interest only saves tax if the firm has taxable profits to set it against. If interest is so high that profits are wiped out, extra debt gives no further tax relief. Tax rules may also cap deductible interest. Tax rates may change too, which alters the benefit.

Asset security and debt capacity. Lenders prefer to lend against tangible assets they can seize, such as property. A firm with mainly intangible assets or volatile cash flows has less debt capacity. Debt capacity is the amount lenders will lend. It depends on asset security, the stability of cash flows, existing borrowing and interest cover. Other factors you can add: the industry norm, the firm's stage of growth, management's attitude to risk, issue costs, and how much control owners are willing to share.

Key rules to remember

Gearing (debt/equity): Debt ÷ Equity (market or book values); Say which basis you use. Market values are better for valuation; book values are common in loan covenants.
Gearing (debt/total capital): Debt ÷ (Debt + Equity); Use the same basis for debt and equity. Check the definition the question gives.
Interest cover: Profit before interest and tax ÷ Interest; Low cover means higher risk of default and less debt capacity. Lenders often set a minimum in covenants.
Value of geared firm (M&M with tax): Vg = Vu + (Debt × Tax rate); This is the theory. Practical factors explain why firms do not reach the extreme this implies.

How to solve Practical Factors Affecting Gearing Decisions questions

Use this for discussion questions on why a firm limits gearing or what affects a gearing decision, and for short calculation-plus-comment questions.

1Read the scenario and note facts about the firm: asset types, profit stability, current gearing, tax position, lender terms, industry.
2Calculate any ratios asked for, such as gearing and interest cover. Show the formula and the basis used.
3State the theory briefly: M&M with tax favours more debt because of the tax shield.
4Match each scenario fact to a practical factor: bankruptcy costs, agency costs, tax exhaustion, asset security, debt capacity.
5Explain the effect of each factor in one or two sentences. Say why it raises the cost of debt, the cost of equity, or limits borrowing.
6Apply your points to the specific firm. Do not give a generic list.
7Conclude with a recommendation, such as keeping gearing at a moderate level or using secured debt, and mention that the optimal level is hard to measure.

Quickest way: Link fact to factor to effect

When to use it: Use in Section B objective cases and in time-pressed Section C discussion parts.

Underline each fact in the scenario: assets, profits, covenants, tax.
Name the matching factor in a few words.
Write the effect: higher risk, higher return demanded, or less debt available.
For objective questions, pick the option that describes a real limit on the tax benefit of debt, not one that repeats the theory.

Common mistakes in Practical Factors Affecting Gearing Decisions

Saying the tax shield means a firm should always borrow as much as possible.
Students remember M&M with tax and stop there.
Fix: Always follow with the limits: distress costs, agency costs, tax exhaustion and debt capacity.
Writing a generic list of factors with no link to the scenario.
Students learn the list by heart.
Fix: Tie every point to a fact given, such as unstable cash flows or few tangible assets.
Confusing bankruptcy costs with agency costs.
Both arise from high gearing.
Fix: Bankruptcy costs are the costs of failure or distress. Agency costs come from conflict between lenders and owners, shown by covenants and monitoring.
Ignoring tax exhaustion when a firm is making losses or low profits.
Students assume interest always saves tax.
Fix: Check taxable profit. If it cannot absorb the interest, the relief is lost or delayed.
Mixing book and market values when calculating gearing.
Data is given in different forms.
Fix: State the basis and use it consistently for debt and equity.

Worked examples

Example 1

Z Co has profit before interest and tax of $600,000. It has $2,000,000 of 8% loan notes and equity with a market value of $6,000,000. It wants to borrow another $2,000,000 at 10%. Calculate the current and proposed interest cover and debt/equity ratio (market values, assuming equity value is unchanged), and comment.

Show the solution

Current interest = 8% × $2,000,000 = $160,000.
Current interest cover = 600,000 ÷ 160,000 = 3.75 times.
Current debt/equity = 2,000,000 ÷ 6,000,000 = 33.3%.
New borrowing interest = 10% × $2,000,000 = $200,000. Total interest = $360,000.
Proposed interest cover = 600,000 ÷ 360,000 = 1.67 times.
Proposed debt/equity = 4,000,000 ÷ 6,000,000 = 66.7%.
Comment: cover falls sharply, so a small drop in profit could mean missed interest payments. This raises bankruptcy risk, so shareholders will want a higher return and lenders may impose covenants. In practice the equity value would probably fall, so gearing would be higher than shown.

Answer: Interest cover falls from 3.75 to 1.67 times and debt/equity rises from 33.3% to 66.7%. The extra debt brings a tax saving but sharply raises financial risk, so the proposal is risky.

Example 2

A software company has few tangible assets, volatile profits and high growth. Its directors believe that, because interest is tax deductible, it should raise most of its new funds from debt. Discuss whether this is wise.

Show the solution

Start with theory: M&M with tax says debt lowers the cost of capital because of the tax shield.
Asset security: the firm has few tangible assets, so lenders have little security to take. They will lend less, or charge more.
Debt capacity: volatile profits mean interest cover could fall quickly, so lenders will offer limited debt.
Bankruptcy costs: for a software firm, distress would damage customer trust and cause staff to leave, so costs of failure are high.
Agency costs: lenders will probably add covenants limiting dividends, further borrowing and investment freedom, which could hinder growth.
Tax exhaustion: if profits are low or negative in some years, interest cannot be used against tax, so the shield is lost.
Conclude: moderate debt, or equity and retained earnings for growth, is more suitable.

Answer: Heavy debt is not wise. Weak asset security, volatile profits, high distress and agency costs, and possible tax exhaustion all limit debt capacity and outweigh the tax benefit. A mainly equity-financed structure with limited debt is more suitable.

Exam tips

In discussion questions, name the factor, explain its effect, then link it to the scenario. Each point earns marks only when developed.
For the limitations of M&M, list failed assumptions: no distress costs, no agency costs, perfect markets, unlimited tax relief, same borrowing rate for firms and individuals.
In Section A and B objective questions, watch for options that overstate: 'debt is always cheaper' or 'gearing has no effect on value' are rarely correct in a practical context.
When asked for ratios, show the formula and basis. Then add a one-line comment, because interpretation often carries the marks.
Mention that no precise optimal gearing level can be calculated in practice. This shows judgement.

Practice questions from Capital structure theories and practical considerations

Practical Factors Affecting Gearing Decisions: frequently asked questions

What are the main limitations of Modigliani and Miller's theory?

It assumes no bankruptcy costs, no agency costs, perfect capital markets, equal borrowing rates for firms and investors, and full use of the tax shield. In practice, these do not hold, so firms do not use extreme levels of debt.

What is the difference between bankruptcy costs and agency costs?

Bankruptcy costs arise when a firm fails or is in distress, such as legal fees and forced asset sales. Agency costs arise from conflicts between lenders and owners, and show up as covenants, monitoring and higher interest.

What is debt capacity?

It is the amount lenders are willing to lend to a firm. It depends on asset security, stability of cash flows, interest cover and existing borrowing.

What is tax exhaustion?

It is the point where a firm's interest is as large as its taxable profit. Extra debt then gives no extra tax relief, so the benefit of borrowing ends.