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Set out what drives a firm's capital structure

CFA® Level I · Corporate Issuers · 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.

The principal tax advantage of debt financing is that:

  1. interest payments are tax-deductible — correct
  2. dividend payments are tax-deductibleWhy not: Dividends are paid out of after-tax profit, which is the whole asymmetry between debt and equity.
  3. principal repayments are tax-deductibleWhy not: Repaying principal returns borrowed money and is not an expense at all; only the interest is deductible.

Interest is an expense and reduces taxable income; dividends are a distribution of after-tax profit and do not.

A harder one

Adding a moderate amount of debt to an all-equity firm typically:

  1. raises the weighted average cost of capitalWhy not: That happens only past the point where distress costs dominate. At modest levels the tax shield pulls it down.
  2. leaves it unchanged in all circumstancesWhy not: The no-tax Modigliani-Miller result, which the deductibility of interest breaks.
  3. lowers the weighted average cost of capital — correct

Debt is cheaper than equity and its interest is deductible, so modest leverage lowers WACC. The effect reverses once distress risk becomes material.

The hardest tier

A software firm with volatile revenues and almost no tangible assets carries very little debt. This is most consistent with:

  1. an irrational aversion to leverageWhy not: The behaviour is exactly what the theory predicts for this cash flow and asset profile, which makes it rational rather than not.
  2. the absence of any tax shield in the software industryWhy not: Software firms pay corporate tax and deduct interest like anyone else.
  3. trade-off theory, since expected distress costs are high — correct

With unpredictable cash flows and no collateral, the marginal cost of distress overtakes the tax shield at a very low level of debt.

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