This lesson examines the theory and practice of capital structure decisions—the mix of debt and equity used to finance the firm.

4.1 Modigliani-Miller (MM) Propositions

The Modigliani-Miller propositions are foundational to corporate finance theory. MM Proposition I states that, in a perfect market with no taxes, bankruptcy costs, or information asymmetries, the value of a firm is independent of its capital structure. MM Proposition II states that the cost of equity increases with leverage . The House of Training syllabus asks: “Is there an optimal Capital Structure (Debt /Equity)?” .

4.2 Capital Structure in the Real World

In the real world, capital structure matters due to market frictions:

• Taxes: Interest payments are tax-deductible, creating a tax shield that increases firm value.

• Financial Distress Costs: Higher leverage increases the risk and cost of financial distress.

• Agency Problems: Debt can act as a disciplinary device.

• Asymmetric Information: The pecking-order theory suggests a hierarchy of financing choices.

4.3 Optimal Capital Structure

The optimal capital structure is the mix of debt and equity that maximises firm value by balancing the tax benefits of debt against the costs of financial distress. The ACT’s DipTM syllabus requires candidates to “recommend optimal capital structures” as a core learning outcome . The DCU module includes “Evaluating Risk Factors (including environmental and social)” and critiques “the relevant theoretical frameworks and the literature relating to the proposition of an optimal capital structure for a firm” .

4.4 The Treasury Role in Capital Structure

The treasury function plays a key role in advising on capital structure decisions. The House of Training syllabus includes “How Finance/Accounting and Corporate Treasury staff can contribute at all levels of the organisation” . Treasury professionals must understand how capital structure decisions affect the company’s funding costs, risk profile, and credit rating, and they contribute to the execution of capital structure strategies through debt issuance, equity management, and dividend policy.