BUSF_A01.qxd

11.1 Introduction

At several points in this book so far we have encountered the fact that most businesses

raise part of their long-term financing requirements through borrowing. This is some-

times achieved by the issue of loan notes or debentures, but more usually through a

term loan from a bank. These give lenders contractual rights to receive interest, typic-

ally at a predetermined rate and on specified dates. Usually such borrowings have to

be repaid or redeemed, so the contractual rights extend to the amount to be repaid and

to the date of repayment. (Some loan notes are perpetual, that is, they need never be

repaid). The central point about debt finance, in the present context, lies in the fact that

neither interest nor repayments are matters of the borrowing business’s discretion.

Interest on borrowings is an annual charge on profit. This must be satisfied before the

equity shareholders, who in the typical business provide the larger part of the finance,

may participate.

Gearing, the cost of capital and

shareholders’ wealth

In this chapter we shall deal with the following:

‘the use of borrowing as part of businesses’ long-term financing

‘the effect of capital gearing on WACC, the value of the business and the

shareholders’ wealth

‘the traditional view of this effect

11.5 The Modigliani and Miller view of gearing

‘the empirical evidence of the effects of gearing

‘gearing and CAPM

11.7 Capital/financial gearing and operating gearing

‘a conjectural conclusion on gearing – trade-off theory

11.12 Pecking order theory

Chapter 11

Objectives