Capital structure theories - part 1

In this lesson

1. 0:00 Capital structure theories overview
2. 0:27 Introduction to gearing and WACC
3. 2:15 Two opposing forces on WACC
4. 3:42 Why shareholders demand higher returns
5. 5:14 Traditional theory and optimal gearing
6. 7:27 Finding the optimal capital structure

About this lesson

You'll learn why the Weighted Average Cost of Capital (WACC) responds differently to increased gearing, examining two competing forces: the advantage of cheaper debt versus the increased financial risk shareholders face. This foundation is essential for FM and AFM papers, where capital structure decisions directly impact company valuation and financial strategy. The lesson begins by introducing what happens when a company increases its gearing level. Using the WACC formula, you'll see how debt and equity weightings affect overall cost of capital. The key insight is that two opposite effects pull in different directions: debt is cheaper than equity to service, which lowers WACC, but higher debt levels increase financial risk for shareholders, forcing them to demand higher returns and pushing WACC up. Understanding which force dominates at different gearing levels is central to capital structure theory. You'll then meet the traditional theory, which dates back to the 1950s before rigorous mathematical models existed. This theory proposes that an optimal capital structure exists—a "sweet spot" where WACC is minimised and company value maximised. At low gearing levels, the cheapness of debt dominates. At high gearing levels, shareholder concern dominates. Somewhere in the middle lies the minimum cost of capital, though finding it requires trial and error rather than a formulaic approach. This sets the stage for Miller and Modigliani's groundbreaking 1958 and 1963 papers, which attempted to solve this puzzle mathematically and remain foundational to modern financial management study.

Duration: 8m