Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
the WACC line can only continue its downward path if the cost of equity line becomes
less steep. (Remember that the WACC line is the average of the other two.)
The idea of the rate of increase in the cost of equity, as gearing is increased, sud-
denly starting to reduce at high gearing levels seems to defy logic. Why should
investors start to behave contrary to all the theories and evidence of investor reaction
to increasing risk? This suggests a weakness in the MM analysis.11.6 Other thoughts on the tax advantage of debt financing
Miller (1977) showed that the tax benefits of gearing for a particular business will
depend on the personal tax positions of both lenders and shareholders. Thus busi-
nesses will tend to attract investors (both lenders and shareholders) who are suited to
their capital structures. This is known as a clientele effect, where particular policies
attract particular types of investor. If Miller is right about this, the implication is that
businesses should probably try to avoid altering their capital structure because this
would lead to investors selling their loan notes or shares and investing their money in
a business that matches their preferences. This is because the dealing costs involved
with selling and buying securities would have an adverse effect on the wealth of the
investors.
More recently, Dempsey (1991) showed, in the context of the UK tax and financial
environment, that in theory gearing has a relatively small adverse effect on the wealth
of shareholders.
For several decades of the late twentieth century, in the UK, provided that the busi-
ness paid most of its profit as a dividend, and that it was in a normal tax-paying situ-
ation, the tax advantages of borrowing tended not to be too profound. To that extent,
the original MM assumption of no corporate taxes was not an unreasonable one. There
were taxes, but the advantage that they gave debt financing was not that great.
In 1997, the tax rules altered, such that now there are normally significant tax
advantages for the business in having debt finance rather than equity.
It is probably fair to say that the question of the tax benefits of gearing remains
unanswered.11.7 Capital/financial gearing and operating gearing
We saw earlier in this chapter that the existence of debt finance in the capital structure
accentuates the effect of variations in operating (that is, pre-interest) profits on returns
to shareholders. This is because, at any significant level of gearing, the interest pay-
ment represents a large fixed commitment, which must be met irrespective of the level
of operating profit.
There is also a gearing aspect to businesses’ operating activities. That is to say, it is
not just capital gearing that causes returns to shareholders to vary. Virtually all opera-
tions have costs that are fixed, irrespective of the level of sales revenue (fixed costs),
and costs that vary with the level of sales revenue (variable costs). The relative pro-
portions of each of these types of cost, in terms of the total costs, vary from one busi-
ness to another, depending on the nature of the activities. This phenomenon is known
as operating gearing. A business is said to be highly operationally geared when a large
proportion of its total costs are fixed costs.‘
‘