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IAI Actuarial Core Principles · Business Finance

Capital Structure and Dividend Policy: WACC and Modigliani-Miller

Capital structure is the mix of debt and equity a company uses to fund itself. Dividend policy is how it splits profit between payouts and retention. To solve questions, compute the cost of each source, weight them into WACC, then apply Modigliani-Miller and its real-world adjustments to judge the financing and payout choice.

What this chapter covers

This chapter asks two linked questions about a company. How should it raise money, and how much of its profit should it pay back to shareholders? You start with the sources of finance: ordinary shares, preference shares, debt, convertibles and retained profit. You then price each source through its cost and combine them into the weighted average cost of capital (WACC).

The middle of the chapter is theory. Modigliani-Miller shows what happens to value and cost of capital under ideal conditions, with no taxes, no bankruptcy costs and no information gaps. You then relax those conditions. Tax relief on interest favours debt. Financial distress costs, agency costs and information effects push back. The result is a trade-off view of optimal gearing.

The last part moves to payouts. You study why dividends might or might not affect value, what signals they send, and how buybacks, scrip dividends and special dividends differ. This chapter feeds the rest of CB1. WACC is the discount rate in project appraisal. Gearing shows up in company accounts analysis. Corporate governance explains who controls these decisions.

The syllabus puts How corporates are financed at 35% of CB1, the largest single block, and this chapter sits inside it. It also supplies the discount rate and gearing ideas used in evaluating projects and in accounts. The topics suit both MCQs (definitions, direction of effects) and written questions (WACC calculations, explaining Modigliani-Miller with and without tax, discussing a payout decision). Solid command here lifts marks across several parts of the paper.

Capital structure and dividend policy: topics in the order to study them

  1. 1Sources of Corporate FinanceYou need to know what each source is, and its risk and features, before you can price or compare them.
  2. 2Cost of Capital and WACCThis gives you the calculations for cost of equity, cost of debt after tax and WACC, which the theory topics build on.
  3. 3Modigliani-Miller Capital Structure TheoryIt explains how WACC and firm value behave as gearing changes, first without taxes and then with them.
  4. 4Optimal Capital Structure and Gearing Trade-offsIt adds real-world frictions to Modigliani-Miller, so study it right after the base theory.
  5. 5Dividend Policy TheoriesDividend irrelevance reuses the Modigliani-Miller logic, so it is easier once that is clear.
  6. 6Share Buybacks, Scrip and Special DividendsThese are practical payout forms, best studied once you know the theories they are used to illustrate.

How to prepare Capital structure and dividend policy

Treat this chapter as one calculation skill plus two theory arguments. Practise the numbers until they are automatic, then learn to explain the arguments in your own words.

  1. Make a one-page table of the sources of finance with features: cost, risk to the company, risk to the investor, tax treatment and control.
  2. Practise WACC from scratch. Compute the cost of equity, the after-tax cost of debt and the market-value weights, then combine them. State your assumptions on the page.
  3. Learn Modigliani-Miller in two versions: no taxes, then with corporate tax. For each, write what happens to the cost of equity, WACC and firm value as gearing rises.
  4. Write a short list of the forces against high gearing, such as distress costs, agency costs and loss of flexibility, and pair each with the tax benefit of debt to explain a trade-off.
  5. Summarise the dividend theories side by side: irrelevance, preference for current dividends, tax effects and signalling. Note the assumptions behind each.
  6. Compare buybacks, scrip dividends and special dividends by effect on cash, share count, control and signals. Then do past-style MCQs and one written question under time.

Common mistakes in Capital structure and dividend policy

  • Using book values instead of market values for WACC weights.

    Fix: Use market values when the question gives them, and say so. Use book values only if market values are not available.

  • Forgetting the tax adjustment on the cost of debt.

    Fix: Check for a tax rate every time. Apply the (1 − tax rate) factor to the cost of debt before weighting.

  • Saying Modigliani-Miller proves gearing never matters.

    Fix: State the conditions: no taxes, no distress costs, perfect markets. Then show what changes when tax is added.

  • Giving only the benefits of debt in a discussion question.

    Fix: Always give both sides and conclude with the trade-off. Link points to the company's situation in the question.

  • Treating dividend theories as facts instead of arguments with assumptions.

    Fix: For each theory, write its key assumption and one real-world reason it may fail.

  • Mixing up buybacks, scrip dividends and special dividends.

    Fix: Use a three-row comparison on cash outflow, shares in issue and signalling. Revise it the day before the exam.

Last-day revision: Capital structure and dividend policy

  • Capital structure is the debt and equity mix; WACC is the cost of each source weighted by its proportion of total capital.
  • Use market values for the weights in WACC where they are available.
  • Interest is usually tax deductible, so the cost of debt after tax is the pre-tax cost × (1 − tax rate).
  • Debt is cheaper than equity for the company because lenders rank first and bear less risk.
  • M&M without taxes: firm value and WACC do not depend on gearing.
  • M&M without taxes: the cost of equity rises as gearing rises, offsetting the cheaper debt.
  • M&M with corporate tax: value rises with gearing because of the interest tax shield, so WACC falls.
  • Against debt: financial distress costs, agency costs and loss of financing flexibility.
  • Trade-off theory: the optimal gearing balances the tax benefit of debt against distress costs.
  • Dividend irrelevance holds only under ideal assumptions, with no taxes or transaction costs and equal information.
  • Dividend changes can signal management's view of future profits.
  • A buyback cuts the number of shares in issue; a scrip dividend issues new shares instead of cash.

Capital structure and dividend policy practice questions

Capital structure and dividend policy 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 and dividend policy: frequently asked questions

Is capital structure and dividend policy a calculation or theory chapter?

Both. WACC and cost of capital need working, while Modigliani-Miller, gearing trade-offs and dividend theories are tested through explanation and discussion. Prepare for numerical and written styles.

Which Modigliani-Miller result should I learn first?

Start with the no-tax case, where firm value and WACC are unaffected by gearing. Then add corporate tax to see why value rises with debt. This order makes the later trade-off discussion easier.

How do I decide between book and market value weights in WACC?

Prefer market values because they reflect what investors would require today. If the question gives only book values, use them and state that assumption clearly.

Can I use the same logic for dividends as for capital structure?

Partly. The dividend irrelevance argument uses the same perfect-market ideas as Modigliani-Miller. In practice taxes, costs and signalling matter, so discuss both views.