Charta is on Google Play: practise on the go. Get the app
Charta

Set out what drives a firm's capital structure

CFA® Level I · Corporate Finance · Capital Structure · CI.1.a

The idea

Capital structure is the mix of debt and equity used to finance a firm. Interest is tax-deductible, so debt carries a tax shield that lowers the weighted average cost of capital - but rising leverage raises the probability and cost of financial distress. The trade-off theory sets the optimum where the marginal tax benefit meets the marginal distress cost. Pecking order theory argues managers prefer internal funds first, then debt, then equity, because issuing equity signals overvaluation. Stable, asset-rich cash flows support more debt than volatile ones.

A practice question

From the question bank, with the reason each wrong option is wrong.

Capital structure refers to a firm's:

  1. distribution of shareholdersWhy not: That is the ownership register, which says who holds the equity rather than how much equity there is against debt.
  2. mix of debt and equity financing - correct
  3. mix of current and fixed assetsWhy not: That is asset structure, the left-hand side of the balance sheet. Capital structure is how the right-hand side is composed.

Capital structure means how a company pays for what it owns. Some money comes from lenders (debt) and some from owners (equity). The question is about that mix, not about who the owners are or what the company owns. Idea: Capital structure = Debt : Equity. Assets such as cash, stock and machinery sit on the other side of the balance sheet, the list of what a firm owns and owes. That is asset structure, which is a different topic.

A harder one

Pecking order theory predicts that managers prefer to finance in which order?

  1. Internal funds, then debt, then equity - correct
  2. Equity, then debt, then internal fundsWhy not: Exactly reversed. Equity is the last resort precisely because issuing it signals overvaluation.
  3. Debt, then equity, then internal fundsWhy not: Puts retained cash last, when it is the cheapest source and carries no signalling cost at all.

Pecking order theory says managers choose funding in the order that is cheapest in terms of what it tells outsiders. Managers know more about the firm than investors do (information asymmetry). Rule: Order = Internal funds, then Debt, then New equity. Using retained profit tells nobody anything. Debt is a fixed claim, so its value changes little with managers' private knowledge. Issuing shares hints that managers think the shares are overpriced, which can push the price down, so equity comes last.

The hardest tier

The corporate tax rate is cut substantially. All else equal, the optimal level of debt under trade-off theory:

  1. falls, because the tax shield is worth less - correct
  2. rises, because after-tax profits are higherWhy not: Higher retained profit reduces the need to borrow, and in any case the benefit being traded off is the shield, which has shrunk.
  3. is unchanged, because distress costs are unaffectedWhy not: Distress costs are one side of the trade-off. The other side has just moved, so the optimum moves with it.

The question asks what happens to the best amount of debt when the tax rate falls. Trade-off theory weighs the tax shield against distress costs. Formula: Tax shield = Interest x Tax rate. A lower tax rate makes each dollar of interest save less tax, so the benefit of debt shrinks. The cost of distress has not changed. The two now balance at a lower level of debt, so the optimal amount of debt falls.

In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Capital Structure