Describing Gearing and Its Importance in Capital Structure of a Company

Decent Essays
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
Get Access