Summary
Capital (financial) gearing (CG)
lCG means financing partly through fixed-return finance (in practice, usually
borrowing, rather than preference shares).
lBorrowing is relatively cheap because
llow risk to lenders
ltax deductible.lCG has the potential to increase returns to shareholders.
lCG has the effect of increasing the variability (risk) of returns to shareholders.
Traditional view
lThe two reasons for borrowing being cheap lead to lowering WACC.
lShareholders and lenders unconcerned about increased risk at lower levels of
gearing.
lAs gearing increases, both groups start to be concerned – higher returns
demanded – WACC increases.
lWACC decreases (value of equity increases) as gearing is introduced – reaches
a minimum – starts to increase again – optimum level of gearing.
12.2 Modigliani and Miller on dividends
lShareholders immediately concerned by the existence of gearing.
lIgnoring taxes, ‘cheap’ debt finance precisely offset by increasing cost of
equity so WACC remains constant at all levels of gearing – no optimum level
- managers should not concern themselves with gearing questions.
lWith tax, interest cheap enough to cause WACC to fall despite increasing cost
of equity – all-debt-financing conclusion – illogical since interest rates would
increase at high levels of gearing.
Modern view: trade-off theory
lMM probably right that gearing is beneficial only because of tax relief.
lAt high levels of gearing, the costs of the business going into enforced liquida-
tion (bankruptcy) become significant.
lGenerally well supported by the evidence.
lConclusion: businesses should gear up to a point where the benefits of tax
relief are balanced by potential costs of bankruptcy – here WACC will be at a
minimum and value of the business at a maximum.
Pecking order theory
lManagers reluctant to make new share issues because
lshare issues have high issue costs;
lmany managers believe that the market undervalues their business’s
shares; and
lsome managers believe that the market views a share issue as an act of
desperation.Summary
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