A company with low gearing is one that is mainly being funded or financed by share capital (equity) and reserves, whilst the one with a high gearing is mainly funded by loan capital. Now the question to address is which of the two (equity and debt) is cheaper to the company? The answer is that cost of debt is cheaper than cost of equity. This is because debt is less risky than equity and the tax advantage of debt over equity as discussed below:
Risk: debt is less risky than equity because:
• the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors;
• the payment of interest is often a fixed amount and compulsory in nature and it is paid in priority to the
…show more content…
Increased possibility of bankruptcy: at very high levels of gearing, shareholders will start to face bankruptcy risk. This is defined as the risk of a company failing to meet its interest payments commitment and hence putting the company into liquidation. This is because interest payment may become unsustainable if profits decrease or interest payments on variable rate debt increase.
Reduced credibility on the stock exchange: at a very high level of gearing, investors will be reluctant to buy the company’s shares or to offer further debt.
The encouragement of short-termist behaviour: in order to prevent bankruptcy, managers may focus on the short-term need to meet interest payment rather than long term objective of wealth maximisation.
Effects of capital gearing upon WACC, company value and shareholder wealth
The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Some companies could be all-equity-financed and have no debt at all, whilst others could have low levels of equity and high levels of debt. The decision on what mixture of equity and debt capital to have is called the financing decision.
The financing decision has a direct effect on the weighted average cost of capital (WACC). The weighted-average cost of capital (WACC) represents the overall cost of capital for a company, incorporating the costs of equity, debt and preference share capital, weighted according to the
Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the
2) The higher ratio of Debt to Total Equity may result to the lower of the debt credit rating. The lower of the credit rating will result to increase of the interest rate which will cost more to the company.
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
1. to preclude the company from trading out of its temporary insolvency, thus resulting in creditors not being fully paid in respect of their debt; and
If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.
From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.
For example, if the public thinks that the firm’s prospects are rosy but the managers see trouble ahead, these managers would view their debt-as well as their equity-as being overvalued. That is, the public might see the debt as nearly risk- free, whereas the mangers see a strong possibility of default.
A firm can choose a mix of three modes of financing i.e. issuing shares, borrowing from the market and use of retained earnings. The ratio of this mix of funds purely depends on the firm and known as optimal capital structure of the firm. This leads to the different capital structure theories. These theories explain their
* Thus decision to use preferred stock or debt exposes the common stockholders to financial risk.
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm 's capital structure is then the composition or 'structure ' of its liabilities. Simply, capital structure refers to the mix of debt and equity used by a firm in financing its assets. The capital structure decision is one of the most important decisions made by financial management. The capital structure decision is at the center of many other decisions in the area of corporate finance. These include dividend policy, project financing, issue of long term securities, financing of mergers, buyouts and so on. One of the many objectives of
The purpose of the report is to understand the capital structure of the chosen company on the basis of the financial statements of the company which includes the income statement, balance sheet and the cash flow statement of the company and do the capital analysis of the company as well to find out the advantages and disadvantages in working capital of the company and suggest company logical and useful ways for growing their economy.
In above case there might be companies that are healthy and many go through period of financial distress. In particular is the threat of not being able to meet debt obligations.
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
The purpose of this document is to detail the various steps needed to install, make ready, and mount an IDE disk on a Linux system. The process starts first with the cabling and physical installation of the disk. Next it is key to ensure the computer’s BIOS is properly configured to allow access to the drive. Once the machine can see the physical drive the next step is to prepare the drive to accept data by partitioning the drive for the desired disk layout. Finally, the drive is mounted within the filesystem hierarchy so it may be accessed by the end user.
Now, the advantages of debt capital centre on its relative cost. Debt capital is usually cheaper than equity because, the pre-tax rate of interest is invariably lower than the return required by shareholders. This is due to the legal position of lenders who have a prior claim on the distribution of the company’s income and who in liquidation precede ordinary shareholders in the queue for the settlement of claims. Debt is usually secured on the firm’s assets, which can be sold to pay off lenders in the event of default, i.e. failure to pay interest and capital according to the pre-agreed schedule;