What is gearing?

  • The mixture of debt finance relative to equity finance that a company uses to finance its business operations
  • Gearing ratios assess financial risk:
  • Debt/equity ratio: D/E
  • Capital gearing: D/(D+E)
  • Market values preferred to book values
  • Should D include short-term debt?

Implications of high gearing

  • Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders.
  • Increased risk of bankruptcy also occurs.
  • Stock exchange credibility falls as investors learn of company’s financial position.
  • Short-termism moves managers’ focus away from maximisation of shareholder wealth.

Optimal capital structure

Key question:

  • Does the mix of debt and equity finance used by a company affect its weighted average cost of capital?
  • Is there a mix of debt and equity that will minimise the average cost of capital?
  • Minimum cost of capital will maximise market value of company and hence maximise shareholder wealth.

Simplifying assumptions

  • No taxes exist.
  • Financing choice is between ordinary shares and perpetual debt.
  • Capital structure changes incur no cost and entail replacing debt with equity or vice versa.
  • All earnings are paid out as dividends.
  • Business risk is constant over time.
  • Earnings and hence dividends are constant.

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