Learning Outcomes
After reading this article, you will be able to explain the main measures of gearing and their impact on risk, interpret beta in financial decision-making, compare key capital structure theories (traditional view, Modigliani & Miller, and pecking order), and apply these ideas to real-world capital structure decisions. You will also recognise practical factors affecting optimal financing choices for ACCA FM exam scenarios.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand how a company’s capital structure affects its cost of capital and value. You should be confident in:
- Calculating and interpreting operating and financial gearing ratios
- Explaining how capital structure impacts company risk and value
- Describing and comparing traditional, Modigliani & Miller, and pecking order theories of capital structure
- Understanding the concept of beta and how it relates to business and financial risk
- Discussing the trade-offs and practical considerations (like bankruptcy, agency costs, and tax) that influence real-world capital structure decisions
- Applying these concepts when selecting an appropriate project discount rate (including the use of CAPM and WACC)
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.
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Which ratio best measures a company's use of debt relative to equity in its capital structure?
- Current ratio
- Operating gearing
- Financial gearing
- Dividend yield
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True or false? According to Modigliani and Miller (with tax), increasing debt always reduces the company's weighted average cost of capital (WACC).
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What does the beta factor represent in the context of the Capital Asset Pricing Model (CAPM)?
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The pecking order theory states that firms generally prefer to use:
- Equity first, then debt
- Internally generated funds, then debt, then equity
- Debt first, then retained earnings
- Any mix—the sequence is irrelevant
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Name two practical reasons why a highly geared company might face problems even if debt is theoretically "cheaper" than equity.
Introduction
Company financing choices have a direct impact on risk and value, and are a frequent topic in ACCA FM exams. Understanding how much debt (gearing) is appropriate, what affects risk, how theories guide capital structure, and which practical limitations apply is critical for effective decision-making—and for exam success.
This article covers how to measure gearing and interpret its impact on both company value and risk, explains the meaning of beta, and contrasts key structure theories—especially traditional, Modigliani & Miller (M&M), and pecking order theory. You will also learn why practical issues often limit how much debt a company actually takes on in real life.
Key Term: Gearing
The proportion of a company's capital that is financed by debt rather than equity. High gearing indicates greater use of debt, which generally increases financial risk for shareholders.
GEARING AND ITS MEASURES
Understanding a company’s capital structure begins with the concept of gearing.
Operating vs Financial Gearing
- Operating gearing focuses on a firm's cost base.
- High operating gearing means a larger proportion of fixed costs, which increases business risk.
- Financial gearing measures the use of debt finance (relative to equity), indicating how much financial risk equity holders face.
Key Term: Operating Gearing
The extent to which a firm's operating costs are fixed rather than variable; higher operating gearing increases business risk because earnings become more sensitive to changes in sales.Key Term: Financial Gearing
The degree to which a company is financed by debt (including preference shares) as opposed to equity; high financial gearing magnifies the effect of earnings variability on shareholder returns.
Key Gearing Ratios
- Equity (Debt/Equity) Gearing:
- Capital Gearing:
- Interest Cover Ratio:
The higher the gearing, the greater the risk that equity holders' returns will fluctuate. Companies with high operating and high financial gearing are considered riskier, as profits are more volatile and there is a greater risk of insolvency if profits fall.
Worked Example 1.1
A company has fixed costs of $600,000 and variable costs of $400,000. Its sales revenue is $1,500,000. Interest on debt is $200,000. Calculate (a) operating gearing and (b) interest cover.
Answer:
Operating gearing = Fixed costs / (Fixed costs + Variable costs) = $600,000 / $1,000,000 = 0.6
Interest cover = Profit before interest and tax ($1,500,000 – $600,000 – $400,000 = $500,000) / $200,000 = 2.5 times
BETA, BUSINESS RISK, AND FINANCIAL RISK
Gearing changes both the riskiness of the company and how investors view required returns.
Key Term: Beta (β)
A measure of the sensitivity of a company's returns to fluctuations in the market as a whole. Beta reflects the systematic risk of an investment—risk that cannot be diversified away.
Beta is used in the Capital Asset Pricing Model (CAPM) to estimate the return required by equity holders.
A higher beta means greater volatility relative to the market, and therefore a higher required return.
- Asset beta: Measures business risk only (i.e., without the impact of gearing).
- Equity beta: Measures both business risk (from the company's operations) and financial risk (from gearing).
Key Term: Asset Beta
The beta that reflects the systematic risk of a company's core business activities, excluding the effect of financial structure (gearing).Key Term: Equity Beta
The beta reflecting both business risk and financial (gearing) risk as faced by shareholders.
Worked Example 1.2
Tech PLC has an equity beta of 1.4, whereas a similar unleveraged technology company has an asset beta of 0.8. What does this tell you about Tech PLC's capital structure and risk compared to the unleveraged company?
Answer:
Tech PLC’s higher equity beta suggests it is more geared, exposing shareholders to greater risk (volatility of returns). The similar asset beta shows their core business risks are alike, but Tech PLC’s use of debt has increased risk to equity holders.
CAPITAL STRUCTURE THEORIES
How does gearing affect value? Several classic theories address this question and appear frequently in ACCA FM exams.
Traditional View
The traditional theory (also known as the intuitive view) suggests:
- Initially, adding (cheap) debt lowers overall WACC and increases company value, as debt is less costly than equity.
- Beyond a certain point, increased risk to shareholders pushes up the cost of equity sharply, offsetting the benefit of cheap debt.
- There is, therefore, an optimal level of gearing where WACC is minimised and company value is maximised.
Key Term: Weighted Average Cost of Capital (WACC)
The average rate a company pays for its long-term finance, calculated as the weighted average of the cost of equity and cost of debt (after tax).
Modigliani & Miller (M&M) Theory—No Tax
M&M’s theory in a world without tax:
- Assumes perfect capital markets, no tax, and rational investors.
- Increasing debt has no effect on WACC or total company value.
- While debt is cheaper, increased gearing makes equity riskier and pushes up required return exactly enough to offset the lower cost of debt.
- Therefore, capital structure is irrelevant.
Modigliani & Miller (M&M) Theory—With Tax
When corporate tax is included:
- Interest is tax-deductible, so debt becomes even cheaper after tax.
- The tax shield means higher gearing always reduces WACC, so company value is maximised at very high gearing.
- However, real companies face practical barriers (see below).
Key Term: Tax Shield
The reduction in tax due to interest payments on debt, making debt finance cheaper for companies.
THE TRADE-OFF, PECKING ORDER, AND PRACTICAL FACTORS
Theoretical models alone rarely determine capital structure in practice. Real-world companies face additional constraints.
Trade-off Theory
The trade-off view recognises that raising debt brings both benefits (tax shield, cheaper cost) and costs (bankruptcy risk, agency costs, constraints from lenders). Companies weigh these factors to find a sensible gearing “window”.
Key Term: Agency Costs
Costs resulting from conflicts of interest between managers and financiers or shareholders, including costs of monitoring and contractual restrictions imposed by lenders.
Pecking Order Theory
Firms prefer to finance investments using (in order):
- Retained earnings (internal funds)
- Debt
- New equity
This order reflects transaction costs, information asymmetry (managers know more than outside investors), and the impact of market perceptions on share issues.
Key Term: Pecking Order Theory
The theory that companies fund new investments first from internal resources, then from debt, and only as a last resort from new share issues, mainly due to the costs and signals associated with each option.
Practical Factors Limiting Gearing
- Bankruptcy risk: At high levels of debt, financial distress and insolvency become real concerns.
- Agency costs: Lenders can impose restrictive covenants, monitoring costs, and may limit future borrowing.
- Tax exhaustion: If interest payments exceed profits, no further tax advantage is gained.
- Borrowing capacity: Assets used for security are finite.
- Market conditions: High gearing can trigger higher borrowing costs due to perceived risk.
- Management and board attitudes: Directors may avoid riskier structures to protect jobs or reputation.
- Legal restrictions: Company constitutions, laws, or lending agreements may cap allowable debt.
Worked Example 1.3
Why might two firms in the same sector have different optimal gearing ratios in practice, even if the theory says very high gearing is best?
Answer:
Real differences in asset quality, earnings volatility, management attitudes, and lender restrictions mean the actual optimal point for each firm may differ. One might approach the theoretical limit, while another halts at lower gearing due to practical concerns.
Exam Warning
It is easy to confuse the implications of different capital structure theories. For FM exam purposes:
- M&M with no tax: Capital structure is irrelevant.
- M&M with tax: More debt reduces WACC—in theory, maximum gearing is best.
- Traditional view: There is a minimum WACC at an optimal gearing—not at maximum debt. In practice, always discuss real-world constraints alongside any theoretical answer.
Summary
The optimal mix of debt and equity is a balancing act. While theory offers clear rules under simplified assumptions, practical issues such as bankruptcy risk, agency costs, and company-specific factors ultimately determine the actual capital structure. The pecking order theory explains why firms often avoid share issues. ACCA FM candidates must be able to calculate gearing, interpret beta, explain the main capital structure theories, and discuss practical factors influencing real-world decisions.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and calculate operating and financial gearing ratios
- Explain how gearing impacts risk and company value
- Distinguish between the traditional view, M&M (with and without tax), and pecking order theory
- Define and interpret beta (asset and equity) in capital structure decisions
- Identify key practical limitations to increasing gearing in real companies
- Discuss the trade-off between benefits and costs of debt, and the reasons for real-world funding choices
Key Terms and Concepts
- Gearing
- Operating Gearing
- Financial Gearing
- Beta (β)
- Asset Beta
- Equity Beta
- Weighted Average Cost of Capital (WACC)
- Tax Shield
- Agency Costs
- Pecking Order Theory