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
- 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.
- 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.
How to write an essay: 論文代寫