Chapter 5: Capital structure (gearing) and financing

Chapter learning Objectives

Upon completion of this chapter you will be able to:

  • explain the basic principles of capital structure theory and identify the major factors which would influence the optimum capital mix and structure for a firm
  • in a scenario question, within a specified business context and capital asset structure, recommend the optimum capital mix and structure for a firm
  • describe pecking order theory and assess the impact it has on the financing of investment decisions
  • describe static trade-off theory (that the optimal capital structure involves a trade off between the tax benefits of debt and the increased bankruptcy costs of debt) and assess the impact it has on the financing of investment decisions
  • describe the agency effects on capital structure and assess the impact it has on the financing of investment decisions.

1 Introduction

A financial manager often has to decide what type of finance to raise in order to fund the investment in a new project.

This chapter covers the key practical and theoreticalconsiderations which influence the basic financing decision i.e. shoulddebt or equity finance be used?

Then, the chapter explains the main features of the key debt and equity financing options.

2 The basic financing decision - debt or equity

Practical considerations

The following diagram summarises the main practical factors whichmust be considered when choosing between debt and equity finance.

More detail on practical considerations

Ongoing servicing costs

Debt is usually cheaper than equity due to lower risk faced by theproviders of finance and the tax relief possible on interest payments.However, some debt, such as an unsecured overdraft, may be moreexpensive than equity.

Issue costs

The costs of raising debt are usually lower than those for issuingnew shares (e.g. prospectus costs, stock exchange fees, stamp duty).


Debt and preference shares give rise to fixed payments that must bemade before ordinary shareholder dividends can be paid. These methodsof finance thus increase shareholder risk.

Optimal capital structure

This was previously covered in Paper F9, and is discussed furtherbelow. You will remember that firms have to make a trade-off between thebenefits of cheap debt finance on the one hand and the costs associatedwith high levels of gearing (such as the risk of bankruptcy) on theother. If the correct balance can be achieved, the cost of finance willfall to a minimum point, maximising NPVs and hence the value of thefirm.

Availability of sources of finance

Not all firms have the luxury of selecting a capital structure tomaximise firm value. More basic concerns, such as persuading the bank torelease further funds, or the current shareholders to make a furtherinvestment, may override thoughts about capital structure.

Tax position

The tax benefits of debt only remain available whilst the firm is in a tax paying position.


Some firms operating in high risk industries use mainly equityfinance to gain the flexibility not to have to pay dividends shouldreturns fall.

Cash flow profile

Cash flow forecasts are central to financing decisions – e.g.ensuring that two sources of finance do not mature at the same time.

Risk profile

Business failure can have a far greater impact on directors than ona well-diversified investor. It may be argued that directors have anatural tendency to be cautious about borrowing.


There may be restrictions imposed on the level of gearing, eitherby the company’s Articles of Association (the internal regulationsthat govern the way the company must be run), or by previous loanagreements.

Theoretical considerations

The main capital structure theories assess the way in which achange in gearing / capital structure impacts on the firm's weightedaverage cost of capital (WACC).

The theories consider the relative sizes of the following two opposing forces:

First, debt is (usually) cheaper than equity:

  • Lower risk.
  • Tax relief on interest.

so we might expect that increasing proportion of debt finance would reduce WACC.


Second, increasing levels of debt makes equity more risky:

  • Fixed commitment paid before equity – finance risk.

so increasing gearing (proportion of finance in the form of debt) increases the cost of equity and that would increase WACC.

The theories attempt to answer the question:

The traditional view

Also known as the intuitive view, the traditional view has notheoretical basis but common sense. It concludes that a firm should havean optimal level of gearing, where WACC is minimised, BUT it does nottell us where that optimal point is. The only way of finding the optimalpoint is by trial and error.

The traditional view explained

At low levels of gearing:

Equity holders see risk increases as marginal as gearing rises, sothe cheapness of debt issue dominates resulting in a lower WACC.

At higher levels of gearing:

Equity holders become increasingly concerned with the increasedvolatility of their returns (debt interest paid first). This dominatesthe cheapness of the extra debt so the WACC starts to rise as gearingincreases.

At very high levels of gearing:

Serious bankruptcy risk worries equity and debt holders alike so both Ke and Kd rise with increased gearing, resulting in the WACC rising further.

This can be shown diagrammatically:


Ke is the cost of equity

Kd is the cost of debt, and

Ko is the overall or weighted average cost of capital.


There is an optimal level of gearing – point X.


There is no method, apart from trial and error, available to locate the optimal point.

Modigliani and Miller's theory (with tax)

Modigliani and Miller's "with tax theory" concluded that because ofthe tax advantages of issuing debt finance (tax relief on debtinterest) firms should increase their gearing as much as possible. Thetheory is based on assumptions such as perfect capital markets.

Modigliani and Miller's theory explained

The starting point for the theory is that:

  • as investors are rational, the required return of equity is directly linked to the increase in gearing – i.e. as gearing increases, Ke increases in direct proportion.

However, this is adjusted to reflect that:

  • debt interest is tax deductible so the overall cost of debt to the company is lower than in MM – no tax
  • lower debt costs imply less volatility in returns for the same level of gearing, giving smaller increases in Ke
  • the increase in Ke does not offset the benefit of the cheaper debt finance and therefore the WACC falls as gearing is increased.


Gearing up reduces the WACC, and the optimal capital structure is 99.9% gearing.

This is demonstrated in the following diagrams:

In practice firms are rarely found with the very high levels ofgearing as advocated by Modigliani and Miller. This is because of:

  • bankruptcy risk
  • agency costs
  • tax exhaustion
  • the impact on borrowing/debt capacity
  • differences in risk tolerance levels between shareholders and directors
  • restrictions in the Articles of Association
  • increases in the cost of borrowing as gearing increases.

As a result, despite the theories, gearing levels in real firms tend to be based on more practical considerations.

Key practical arguments against M+M

Bankruptcy risk

As gearing increases so does the possibility of bankruptcy. Ifshareholders become concerned, this will reduce the share price andincrease the WACC of the company.

Agency costs: restrictive conditions

In order to safeguard their investments lenders/debentures holdersoften impose restrictive conditions in the loan agreements thatconstrains management’s freedom of action.

E.g. restrictions:

  • on the level of dividends
  • on the level of additional debt that can be raised
  • on management from disposing of any major fixed assets without the debenture holders’ agreement.

Tax exhaustion

After a certain level of gearing companies will discover that theyhave no tax liability left against which to offset interest charges.

Kd(1-t) simply becomes Kd.

Borrowing/debt capacity

High levels of gearing are unusual because companies run out ofsuitable assets to offer as security against loans. Companies withassets, which have an active second-hand market, and low levels ofdepreciation such as property companies, have a high borrowing capacity.

Difference risk tolerance levels between shareholders and directors

Business failure can have a far greater impact on directors than ona well-diversified investor. It may be argued that directors have anatural tendency to be cautious about borrowing.

Test your understanding 1

X Co, an unquoted manufacturing company, has been experiencing agrowth in demand, and this trend is expected to continue. In order tocope with the growth in demand, the company needs to buy furthermachinery and this is expected to cost 30% of the current company value.

In the past, a high proportion of earnings has been distributed byway of dividends so few cash reserves are available. 51% of the sharesin X Co are still owned by the founding family.

A decision must now be taken about how to raise the funds. The firmhas already raised some loan finance and this is secured against thecompany land and buildings.

Suggest the issues that should be considered by the board in determining whether debt would be an appropriate source of finance.

3 Real world approaches to the gearing question

Static trade-off theory

It is possible to revise M and M’s theory to incorporatebankruptcy risk and so to arrive at the same conclusion as thetraditional theory of gearing – i.e. that an optimal gearing levelexists.

Given this, firms will strive to reach the optimum level by means of a trade-off.

Static trade-off theory argues that firms in a stable (static)position will adjust their current level of gearing to achieve a targetlevel:

Above target debt ratio the value of the firm is not optimal:

  • Financial distress and agency costs exceed the benefits of debt.
  • Firms decrease their debt levels.

Below the target debt ratio can still increase the value of the firm because:

  • marginal value of the benefits of debt are still greater than the costs associated with the use of debt
  • firms increase their debt.

NB: Research suggests that this theory is not backed up by empirical evidence.

Pecking order theory

Pecking order theory tries to explain why firms do not behave theway the static trade-off model would predict. It states that firms have apreferred hierarchy for financing decisions:

The implications for investment are that:

  • the value of a project depends on how it is financed
  • some projects will be undertaken only if funded internally or with relatively safe debt but not if financed with risky debt or equity
  • companies with less cash and higher gearing will be more prone to under-invest.

If a firm follows the pecking order:

  • its gearing ratio results from a series of incremental decisions, not an attempt to reach a target
    • High cash flow ⇒ Gearing ratio decreases
    • Low cash flow ⇒ Gearing ratio increases
  • there may be good and bad times to issue equity depending on the degree of information asymmetry.

A compromise approach

The different theories can be reconciled to encourage firms to make the correct financing decisions:

(1) Select a long run target gearing ratio.

(2) Whilst far from target, decisions should be governed by static trade-off theory.

(3) When close to target, pecking order theory will dictate source of funds.

Test your understanding 2

What factors about the raising and servicing the various sources of funds may explain the order of preference of most companies?

More on pecking order v static trade off

Pecking order theory was developed to suggest a reason for thisobserved inconsistency in practice between the static trade-off modeland what companies actually appear to do.

Issue costs

Internally generated funds have the lowest issue costs, debtmoderate issue costs and equity the highest. Firms issue as much as theycan from internally generated funds first then move on to debt andfinally equity.

Asymmetric information

Myers has suggested asymmetric information as an explanation forthe heavy reliance on retentions. This may be a situation wheremanagers, because of their access to more information about the firm,know that the value of the shares is greater than the current marketvalue based on the weak and semi-strong market information.

In the case of a new project, managers forecast maybe higher andmore realistic than that of the market. If new shares were issued inthis situation there is a possibility that they would be issued at toolow a price, thus transferring wealth from existing shareholders to newshareholders. In these circumstances there might be a natural preferencefor internally generated funds over new issues. If additional funds arerequired over and above internally generated funds, then debt would bethe next alternative.

If management is against making equity issues when in possession offavourable inside information, market participants might assume thatmanagement would be more likely to favour new issues when they are inpossession of unfavourable inside information. This leads to thesuggestion that new issues might be regarded as a signal of bad news!Managers may therefore wish to rely primarily on internally generatedfunds supplemented by borrowing, with issues of new equity as a lastresort.

Myers and Majluf (1984) demonstrated that with asymmetricinformation, equity issues are interpreted by the market as bad news,since managers are only motivated to make equity issues when shares areoverpriced. Bennett Stewart (1990) puts it differently: ‘Raisingequity conveys doubt. Investors suspect that management is attempting toshore up the firm’s financial resources for rough times ahead byselling over-valued shares.’

Asquith and Mullins (1983) empirically observed that announcementsof new equity issues are greeted by sharp declines in stock prices.Thus, equity issues are comparatively rare among large establishedcompanies.

Dealing with 'gearing drift'

Profitable companies will tend to find that their gearing levelgradually reduces over time as accumulated profits help to increase thevalue of equity. This is known as "gearing drift".

Gearing drift can cause a firm to move away from its optimalgearing position.  The firm might have to occasionally increase gearing(by issuing debt, or paying a large dividend or buying back shares) toreturn to its optimal gearing position.

Signalling to investors

In a perfect capital market, investors fully understand the reasons why a firm chooses a particular source of finance.

However, in the real world it is important that the firm considersthe signalling effect of raising new finance. Generally, it is thoughtthat raising new finance gives a positive signal to the market: the firmis showing that it is confident that it has identified attractive newprojects and that it will be able to afford to service the new financein the future.

Investors and analysts may well assess the impact of the newfinance on a firm's income statement and balance sheet (statement offinancial position) in order to help them assess the likely success ofthe firm after the new finance has been raised.

Test your understanding 3

A company is considering a number of funding options for a newproject. The new project may be funded by $10m of equity or debt. Beloware the financial statements under each option.

Statement of financial position (Balance sheet) extract

Income statement extract

Corporation tax is charged at 30%.

(a) Calculate ROCE and return on equity (ROE) and compare the financial performance of the company under the two funding options.

(b) What is the impact on the company’s performance of financing by debt rather than equity?

4 Agency effects

Agency costs have a further impact on a firm’s practical financing decisions.

Where gearing is high, the interests of management and shareholders may conflict with those of creditors.

Management may for example:

  • gamble on high-risk projects to solve problems
  • pay large dividends to secure company value for themselves
  • hide problems and cut back on discretionary spending
  • invest in higher risk business areas than the loan was designated to fund.

In order to safeguard their investments lenders/debentures holdersoften impose restrictive conditions in the loan agreements thatconstrains management’s freedom of action: these may includerestrictions:

  • on the level of dividends
  • on the level of additional debt that can be raised
  • on acceptable working capital and other ratios
  • on management from disposing of any major asset without the debenture holders’ agreement.

These effects may:

  • encourage use of retained earnings
  • restrict further borrowing
  • make new issues less attractive to investors.

More on agency effects

In a situation of high gearing, shareholder and creditor interestsare often at odds regarding the acceptability of investment projects.

Shareholders may be tempted to gamble on high-risk projects as ifthings work out well they take all the ‘winnings’ whereas if thingsturn out badly the debenture holders will stand part of the losses, theshareholders only being liable up to their equity stake.

There are further ways in which managers (appointed byshareholders) can act in the interests of the shareholders rather thanthe debt holders:


We have seen how shareholders may be reluctant to put money into anailing company. On the other hand they are usually happy to take moneyout. Large cash dividends will secure part of the company’s value forthe shareholders at the expense of the creditors.

Playing for time

In general, because of the increasing effect of the indirect costsof bankruptcy, if a firm is going to fail, it is better that thishappens sooner rather than later from the creditors’ point of view.However, managers may try to hide the extent of the problem by cuttingback on research, maintenance, etc. and thus make ‘this year’s’results better at the expense of ‘next year’s’.

Changing risks

The company may change the risk of the business without informingthe lender. For example, management may negotiate a loan for arelatively safe investment project offering good security and thereforecarrying only modest interest charges and then use the funds to finance afar riskier investment. Alternatively management may arrange furtherloans which increase the risks of the initial creditors by undercuttingtheir asset backing. These actions will once again be to the advantageof the shareholders and to the cost of the creditors.

It is because of the risk that managers might act in this way thatmost loan agreements contain restrictive covenants for protection of thelender, the costs of these covenants to the firms in terms ofconstraints upon managers’ freedom of action being a further exampleof agency costs.

Covenants used by suppliers of debt finance may place restrictions on:

  • issuing new debt – with a superior claim on assets
  • dividends – growth to be linked to earnings
  • merger activity – to ensure post-merger asset backing of loans is maintained at a minimum prescribed level
  • investment policy.

Contravention of these agreements will usually result in the loanbecoming immediately repayable, thus allowing the debenture holders torestrict the size of any losses.

5 Specific financing options

Recap of basic financing options

The basic choice for a business wanting to raise new finance is between equity finance and debt finance.

Equity finance

This is finance raised by the issue of shares to investors.

Equity holders (shareholders) receive their returns as dividends,which are paid at the discretion of the directors. This makes thereturns potentially quite volatile and uncertain, so shareholdersgenerally demand high rates of return to compensate them for this highrisk.

From the business's point of view therefore, equity is the mostexpensive source of finance, but it is more flexible than debt giventhat dividends are discretionary (subject to the issues discussed inChapter 6: Dividend policy).

Debt finance

Short term debt finance

In the short term, businesses can raise finance through overdrafts or short term loans.

Overdrafts are very flexible, can be arranged quickly, and can berepaid quickly and informally if the company can afford to do so.However, if the bank chooses to, it can withdraw an overdraft facilityat any time, which could leave a company in financial trouble.

A short term loan is a more formal arrangement, which will begoverned by an agreement which specifies exactly what amounts should bepaid and when, and what the interest rate will be.

Long term debt finance

Long term debt finance tends to be more expensive than short termfinance, unless the debt is secured, when the reduction in risk bringsdown the cost. Long term debt tends to be used as an alternative toequity for funding long term investments. It is cheaper than equityfinance, since the lender faces less risk than a shareholder would, andalso because the debt interest is tax deductible. However, the interestis an obligation which cannot be avoided, so debt is a less flexibleform of finance than equity.

Equity financing options

The main options for companies wishing to raise equity finance are:

  • rights issue to existing shareholders - this option is the simplest method, providing the existing shareholders can afford to invest the amount of funds required. The existing shareholders' control is not diluted.
  • public issue of shares - gaining a public listing increases the marketability of the company's shares, and makes it easier to raise further equity finance from a large number of investors in the future. Becoming a listed company is an expensive and time-consuming process, and once listed, the company has to face a higher level of regulation and public scrutiny. Also, since the company's shares are likely to become widely distributed between many investors, the threat of takeover increases when a company becomes listed.
  • private placing - "private equity finance" is the name given to finance raised from investors organised through the mediation of a venture capital company or private equity business. These investors do not operate through the formal equity market, so raising private equity finance does not expose the company to the same level of scrutiny and regulation that a stock market listing would. Private equity is often perceived as a relatively high risk investment, so investors usually demand higher rates of return than they would from a stock market listed company. Business Angels are a source of private equity finance for small companies.

Read Peter Atrill's March 2009 article in Student Accountant magazine ("Being an Angel") for more details on Business Angels.

Stock Exchange listing requirements

If a company decides to raise equity finance from the local capitalmarket, it must comply with the listing requirements of the capitalmarket. For illustration, the listing requirements for the London StockExchange are given below:

Track record requirements

The company must be able to provide a revenue earnings record forat least 75% of its business for the previous 3 years. Also, anysignificant acquisitions in the 3 years before flotation must bedisclosed.

Market capitalisation

The shares must be worth at least £700,000 at the time of listing.

Share in public hands

At least 25% of the shares must be in public hands.

Future prospects

The company must show that it has sufficient working capital forits current needs and for the next 12 months. More generally, adescription of future plans and prospects must be given.

Audited historical financial information

This must be provided for the last 3 full years, and any published later interim period.

Corporate governance

The Chairman and Chief Executive roles must be split, and half theBoard should comprise non-executive directors. There must be anindependent audit committee, remuneration committee and nominationcommittee. The company must provide evidence of a high standard offinancial controls and accounting systems.

Acceptable jurisdiction and accounting standards

The company must be properly incorporated and must use IFRS and equivalent accounting standards.

Other considerations

A sponsor / underwriter will need to make sure that the company hasestablished procedures which allow it to comply with the listing anddisclosure rules.

Debt financing options

A company seeking to raise long term debt finance will be constrained by its size, its debt capacity and its credit rating.

Small and medium sized enterprises (SMEs) may make use of privatelending through family, friends and other small business investors. Theusual starting point is to approach a bank, who will make a lendingdecision based on the company's business plan.

Larger companies have the following additional options:

  • bond issue - this is an attractive way of raising large amounts of debt finance, at a low rate of interest. There are however significant issue costs and there is a risk that the issue might not be fully subscribed (unless it is underwritten). Bonds may be issued in the domestic, or an overseas, capital market.
  • debenture issue - debentures are asset backed securities (i.e. lower risk for investors).
  • convertible bond issue - convertibles carry the right of conversion to equity at some future date. This makes the bond more attractive to a potential investor.
  • mezzanine finance - the most risky type of debt from the lender's point of view. The holder of mezzanine debt is ranked after all the other debt holders on a liquidation, and the debt is unsecured. A high coupon rate has to be paid to compensate the investor for this risk.
  • syndicated loan - for large amounts of debt finance, where one bank is not prepared to take the risk of lending such a large amount, a loan may be raised from a syndicate of banks. Rates of interest tend to be slightly higher than those in the bond market, but transaction costs are low and loans can be arranged much quicker than a bond issue.

6 Chapter summary

Test your understanding answers

Test your understanding 1

Issues to raise would include:

  • Retained earnings – often a preferred source of funds for smaller firms, these cannot be easily used here as the family shareholders expect significant dividends. This means that outside finance must be considered.
  • High level of required funding relative to the size of the firm – could be perceived by potential investors as increasing business risk even though the expansion is in the same industry. This would increase required returns of equity investors before the increase in debt funding is even considered.
  • Assets for loan security – since land and buildings are already mortgaged, the machinery will have to be used as security. The attractiveness of this depends on whether they are specialised or would have a ready resale market.
  • Gearing levels – the company is already geared but it is not clear whether the current level is optimum. Raising further debt finance, subject to the taxation considerations below, should reduce the overall cost of capital, but such a significant sum is likely to be seen as high risk. The fixed interest payments could bankrupt the firm if the expected growth does not occur. This is likely to increase the required returns of shareholders and may mean that debt lenders demand higher returns than are being paid on the current loans.
  • Taxation – the high levels of investment will attract capital allowances. Depending on the current tax position of the firm and the treatment of those allowances by the revenue, the company may find itself in a non tax-paying position. This would negate the benefits of the cheaper debt finance.
  • Agency costs – lenders often impose restrictive covenants on the company. This is particularly likely where such a significant level of funds is to be raised. A company largely in family control may be reluctant to have such restrictions, especially on dividend payments for example, which are appear to be used here to provide the family members with a source of income.
  • Risk profile – the family members may be reluctant to take on further debt. The risk of bankruptcy mentioned above, is of greater concern to undiversified family owners than to the typically well diversified outside investor.
  • Control – since the family retain voting control, the choice may be between debt finance and a rights issue, unless they are willing to give up control. If they do not have the funds to inject, a loan may be the only choice.
  • Consideration should be given to alternatives such as leasing the machinery, or seeking venture capital funding (although that too may also require a loss of absolute family control).

Test your understanding 2

Internally generated funds – i.e. retained earnings

  • Already have the funds.
  • Do not have to spend any time persuading outside investors of the merits of the project.
  • No issue costs.


  • The degree of questioning and publicity associated with debt is usually significantly less than that associated with a share issue.
  • Quicker to raise than equity.
  • Moderate issue costs.
  • Seen as cheaper to service.

New issue of equity

  • Perception by stock markets that it is a possible sign of problems.
  • Extensive questioning and publicity associated with a share issue.
  • Takes time to raise.
  • Expensive issue costs.

Test your understanding 3

The financial performance of the two funding options is exactlythe same for ROCE. This should not be a surprise given that ROCE is anindication of performance before financing, or underlying performance.

(b) When considering the ROE wesee that the geared option achieves a higher return than the equityoption. This is because the debt (10%) is costing less than the returnon capital (25%). The excess return on that part funded by debt passesto the shareholder enhancing their return. The only differences betweenROCE and ROE will be due to taxation and gearing.

Created at 5/24/2012 3:52 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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