Gearing and the cost of capital – conclusionlevels, seems naïve. It appears to conflict with most of the evidence on the effici-
ency of the capital market. Tests of capital market efficiency indicate that little of
significance goes unnoticed. It is difficult to believe that increased levels of gearing
are insignificant to equity shareholders, since gearing increases the range of possible
returns. As most investors seem to be risk-averse, increasing the range of possible
outcomes will be unattractive to them.
The formal evidence on the effects of gearing cited above also cuts across the tradi-
tional view since it appears that gearing levels broadly affect equity returns and
WACC in the manner suggested by MM (after-tax).
On the other hand, casual observation shows that businesses’ managements do not
seem to believe in very high levels of gearing, which rather supports the traditional
view.
There is a conflict here, although perhaps it is possible to reconcile these two
factors.
The MM (after-tax) analysis relies on a number of assumptions, most of which seem
not to be so far-fetched as seriously to weaken their conclusions. Two of them, how-
ever, call their proposition into question. These are (1) that there are no bankruptcy
costs, and (2) that the interest rate demanded by lenders remains the same at all levels
of gearing. We shall now look more closely at these two assumptions.The MM assumptions revisited
‘There are no bankruptcy costs’
The importance of this assumption lies in the fact that the existence of high levels of
debt finance exposes the business to the risk that it will not be able to meet its payment
obligations to lenders, not at least out of its operating cash flows, if the business
should experience a particularly adverse period of trading. While it is equally true that
the all-equity business might have difficulty paying dividends in similar economic cir-
cumstances, there is an important difference.
Lenders have a contractual right to receive interest and capital repayment on the
due dates. If they do not receive these, they have the legal power to enforce payment.
The exercise of such power can, in practice, lead to the liquidation of the assets and the
winding up of the business. For the reasons we have already discussed (principally
through an apparently inefficient market in real assets), this will usually disadvantage
the ordinary shareholder and do so to a significant extent.
This is supported by research evidence. Andrade and Kaplan (1998) estimate, from
a study of 31 businesses that became financially distressed during the 1980s, that the
costs of bankruptcy, or coming close to it, represent between 10 and 20 per cent of the
businesses’ value. If we take a hypothetical bankrupted business that is financed
50/50 by debt and equity, the cost to the shareholders (who would normally bear all
of the cost) represents between 20 and 40 per cent of the value of their investment – a
very significant amount.
By contrast, neither in a geared nor in an ungeared business do ordinary share-
holders have any rights to enforce the declaration and payment of a dividend.
This bankruptcy risk is probably insignificant at low levels of gearing, if only
because any shortage of cash for interest payments could be borrowed from some
other source – a possibility probably not so readily available to highly geared busi-
nesses in distress.