Five reasons why Capital Structure Theory matters for business strategy

He was the darling of investors, the go-to man for an exclusive for the business press; Adam Neumann was not just reinventing the office, with his company WeWork he had somehow made it as exciting as tech giants like Apple. 

This was the 2010s, and with interest rates at an all time low, everyone wanted to be a Silicon Valley unicorn. WeWork’s enigmatic founder and CEO loaded up on cheap debt and investors loved it, with its valuation hitting $47 billion at one point. 

Unfortunately, the pandemic hit, hybrid working took over and WeWork’s mountain of office space was unwanted. In 2023, the company filed for bankruptcy with $3 billion of debt. Its highly leveraged capital structure that had seemed so attractive was now a huge burden. 

In the new high interest rate environment, the cost of servicing that structure rose just as revenues weakened. It was a structure that led to failure and a salutary lesson for business leaders to understand the double-edged sword of their finances.  

Indeed, anyone leading a business needs a deep knowledge of capital structure theory. Here are five reasons why. 

1 Understanding capital structure 

Capital structure is the mix of debt and equity financing a company or organisation. In other words, it is the mix of debt and equity on the liability side of the company’s balance sheet.  

This mix is critical because it helps determine the firm’s risk, its value, and its competitive position. 

While the key components of capital structure are equity and debt, within those there are different forms. On the equity side, there is common equity and preferred equity. On the debt side, there is short‑term and long‑term debt. 

In addition to debt and equity, there are also hybrid financing instruments. These are types of securities that sit in between debt and equity. A common example is convertible bonds, which are technically debt, but can later be converted into equity. Another example would be callable debt, where a firm issues debt -usually as a bond - but retains the option to buy it back later, such as when interest rates fall, so the company can refinance the debt at a lower rate. 

New hybrid instruments are often unveiled and blend features of debt and equity in different ways.  

All these choices together make up a firm’s capital structure. 

2 Cost of capital and its role 

The cost of capital is essentially the return that a firm has to implicitly promise to its investors.  

This includes the return on debt it has issued and also the cost of capital on equity, which is the expected return that equity investors, or shareholders, are demanding. In that sense, the cost of capital reflects what investors require in order to finance the firm. 

Investors can look at a company’s balance sheet and work out the minimum return it needs to make to pay its creditors and shareholders. This is known as the weighted average cost of capital (WACC). A weighted average means it is proportionate to how much debt and how much equity the firm has on its balance sheet.  

It also incorporates the corporate tax rate, because interest on debt allows companies to pay less in tax. Thus, taken together, WACC represents the overall average cost of capital at which the firm is financed. 

In practice, WACC serves as a kind of hurdle rate. It reflects not only what the firm has to expect to earn to compensate its capital investors, but also what it should require when choosing and evaluating potential investment projects.  

More broadly, the cost of capital and WACC are used by companies to decide whether to take or pass on investment opportunities. They reflect the risk and expected returns on a company’s investments and strategic decisions, which makes them critical for determining whether those decisions will be successful or not. 

There is no single 'good' level of WACC. It depends on a firm’s risk, its value creation, its strategic decisions, and its competitive position. It can also vary across industries and over the business cycle.  

Importantly, WACC is not a target to stay below, but a required return that investments must meet or exceed in order to be worth pursuing. 

3 Financial leverage: A double-edged sword 

Key to understanding a company’s capital structure is financial leverage. This is basically a firm’s debt‑to‑equity ratio. In other words, it is a simplistic measure of a firm’s capital structure.

Financial leverage matters because it amplifies equity returns. When a firm takes on more debt, the returns to equity holders can increase if the firm performs well. 

Higher debt and higher financial leverage can be beneficial in several ways. One important role of leverage is that it can discipline management. Debt keeps managers, in a sense, on a tight leash, encouraging them to be more careful and disciplined in their investment strategy. Alongside this, debt can create value through tax advantages, as interest payments reduce the firm’s overall tax burden. 

However, there is a clear flip side. As leverage increases, so does the risk. Higher debt raises the likelihood that a firm will experience financial distress, and in more extreme cases, default or bankruptcy. Excessive leverage, particularly when it is overused, can therefore damage long‑term firm value rather than enhance it. 

This risk becomes especially pronounced in economic downturns. Firms that rely heavily on debt may struggle when economic conditions worsen, even if their strategy looked sound during periods of economic growth. In economic and financial downturns, leverage can quickly shift from being a source of value to a serious vulnerability. 

A prime example of this was the collapse of Lehman Brothers. The US investment bank took on increasing amounts of short-term debt to invest in mortgage‑backed securities. The strategy worked well until housing prices fell and Lehman was unable to refinance its debt, triggering the largest bankruptcy in US history in 2008 of $639 billion. 

4 Influence on corporate finance and strategy 

When we talk about capital structure and its influence on corporate finance and strategy, we start with the foundational work of US economists and Nobel laureates Franco Modigliani and Merton Miller. 

Their theorems were among the first to provide a formal economic framework for thinking about capital structure and, crucially, for asking why capital structure might matter for firm value and for strategic and corporate decision‑making.

One of the primary theories that follows from this work is the trade‑off theory of capital structure. According to this theory, firms should aim for an optimal leverage ratio. That target reflects a trade‑off between the benefits of financial leverage, such as the tax shield debt provides, and the potential costs, particularly the risk and cost of financial distress.  

In this framework, capital structure is not arbitrary: it is shaped by the firm’s risk profile, its industry, competitive environment and overall strategy. 

In contrast, the pecking order theory takes a different view. While firms may have a long‑run target capital structure, this theory emphasises asymmetric information: the firm’s management always knows more about its prospects than outside investors. Because managers cannot fully convey this information in a credible manner directly, it is the firm’s financing actions themselves that become informative. 

As a result, companies prefer to issue the least information‑sensitive securities first. They will use retained earnings - ie profits the company keeps after payouts to shareholders and debt - if possible, then move to debt financing, and only as a last resort issue equity, which is the most information‑sensitive claim on the firm. 

This theory helps explain why equity issuance is rare outside of Initial Public Offerings (IPOs) on stockmarkets and why such secondary offerings often lead to negative stock price reactions. 

Taken together, these capital structure theories explain real corporate behaviour. Firms balance long‑run leverage targets with short‑run financing choices, aligning capital structure with growth plans, industry dynamics, risk tolerance, corporate governance, financial flexibility, and competitive strategy. 

5 Enhancing financial stability and growth 

When we think about enhancing financial stability and long‑term growth, it is important to recognise that financing decisions and payout decisions - meaning dividend policy and potential share repurchases - jointly determine shareholder value.  

Capital structure, which reflects the balance between debt and equity financing, is therefore closely tied to how firms think about dividends. 

In practice, CEOs and CFOs place a strong emphasis on maintaining a steady dividend as they are widely seen as a signalling device that reflects management’s confidence in the firm’s long‑term profitability and sustainability.  

Even though dividends can be tax‑inefficient relative to share repurchases, firms are extremely reluctant to cut them, because a dividend cut is generally interpreted as a very negative signal by investors and often leads to a fall in the share price.  

As a result, increases in dividends tend to be cautious and gradual, even when firms are highly profitable. Ultimately, payouts to equity holders occur only through dividends or repurchases, and firms will typically strive to maintain dividends even when they have relatively high leverage. 

A sound capital structure must also balance short‑term liquidity and financial flexibility with the need for long‑term strategic growth. In the short run, firms prefer to finance investment using retained earnings, but over time, larger investments may require debt financing. Managing this balance is critical for protecting liquidity while enabling sustainable expansion. 

Looking at real‑world case studies, many of the tech giants like Google, Apple, Microsoft, Meta and Amazon hold surprisingly little debt and maintain very large cash balances, despite their size and profitability.  

This reflects the strategic risks inherent in technology markets, where dominance cannot be taken for granted. Holding large cash buffers and low leverage provides strategic flexibility, reduces the risk of financial distress, and allows firms to respond quickly to disruptive threats or make major acquisitions.  

More stable industries, such as utilities or consumer staples, by contrast, can operate safely with much higher levels of debt, reflecting lower strategic and business risk. 

Capital Structure Theory as the backbone of corporate strategy 

Capital structure is not just a narrow finance topic; it is really the backbone of strategic decision‑making within a firm. 

It helps explain a wide range of corporate financial and strategic choices, from investment and financing decisions to how companies manage risk and pursue growth. Understanding capital structure therefore means understanding how businesses actually operate and compete. 

This understanding is not just about formulas to learn. Businesses need to comprehend how financial decisions connect directly to corporate strategy, governance, and long‑term value creation. 

Ultimately, while businesses may rely on judgement and vision, their decisions are grounded in applying deep comprehension of corporate finance through critical evaluation of corporate strategy that is backed by the numbers. 

Further reading:

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David Skeie is Professor of Finance and part of the School's Gillmore Centre for Financial Technology. He is also a member of the Bank of England and HM Treasury Academic Advisory Group on Central Bank Digital Currency. He teaches Corporate Finance on the MSc Business & Finance and Financial Regulation and Supervision on the Global Central Banking and Financial Regulation Qualifications. 

Learn more about finance on the four-day Executive Education course Finance for Non-Finance Leaders at WBS London at The Shard.

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