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Other practical issues relating to capital gearing

If a business is simultaneously highly geared in both operating and capital terms,

relatively small fluctuations in the level of sales revenue can have a dramatic effect

on returns to shareholders. This means that the risk of bankruptcy is greater with

businesses that are highly geared in both senses, particularly where their sales revenue

levels are susceptible to fluctuations from year to year. It is expected that businesses

whose cost structure is such as to make them relatively highly geared on the opera-

tions side tend not to indulge in too much capital gearing.

11.8 Other practical issues relating to capital gearing

Agency costs

The fact that shareholders must, in practice, rely on the directors (the shareholders’

agents) to manage the business can lead to its being managed in a way that may not

always be in the best interests of the shareholders. Were the directors to act in a way

that is less than optimal, from a shareholder wealth maximisation perspective, the

shareholders would bear a cost.

Consider two businesses, High plc and Low plc. Their cost structures are as follows:

Fixed costs per annum Variable costs per £ of sales revenue

High plc £100,000 £0.20

Low plc £50,000 £0.50

For a range of sales revenue figures, operating results would be as shown in Table 11.2.

The table shows that the more highly operationally geared, High plc, shows much greater

fluctuations with alterations in the level of sales revenue than does Low plc. You will remem-

ber that we saw a similar effect with capital gearing in Table 11.1 (page 297).

Example 11.3

Table 11.2Operating results for High plc and Low plc for various levels of sales

revenue

£ £££

Sales revenue 0 200,000 300,000 400,000

High plc

Fixed costs 100,000 100,000 100,000 100,000

Variable costs 0 40,000 60,000 80,000

Total costs 100,000 140,000 160,000 180,000

Operating profit (100,000) 60,000 140,000 220,000

Low plc

Fixed costs 50,000 50,000 50,000 50,000

Variable costs 0 100,000 150,000 200,000

Total costs 50,000 150,000 200,000 250,000

Operating profit (50,000) 50,000 100,000 150,000