Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
In the context of capital gearing, such a cost can arise because gearing may be in the
best interests of the shareholders yet be a less attractive proposition to the directors.
If gearing lowers the cost of capital, shareholders would welcome this. The need to
meet interest payments and to have the funds available to repay borrowings on the
contracted date, however, imposes a discipline on the directors that they might prefer
to avoid. On the other hand, Jensen (1986) pointed out that being forced to make inter-
est payments, at a particular level, might dissuade the directors from making invest-
ments that would not be justified by the returns likely to be generated by those
investments; in other words, the directors would tend to be more careful in taking on
investments that might prove disadvantageous. Thus gearing might discourage the
directors from making such investments as a means of expanding the business and
with it their personal security and wellbeing.Signalling
It has been suggested that borrowing additional amounts can be interpreted, by the
investing public, as signallingthat the directors are confident enough of the future
cash flows that are expected to be generated by the business’s investments to be pre-
pared to expose the business to the need to make regular interest payments to lenders.Clientele effect
It seems likely that particular shareholders are attracted by or, at least, satisfied with
a particular business’s level of capital gearing. That is to say that those shareholders
are content with the risk/return trade-off implied by the business’s level of capital
gearing. As we saw on page 306, investors’ tax positions could also give rise to a clien-
tele effect.
Were the business to alter the level of capital gearing by, for example, increasing
or reducing the level of debt finance, the new level of capital gearing would not suit
many, perhaps most, of the existing shareholders. This shift in gearing levels might
cause some of the shareholders to sell their shares and to buy those of another busi-
ness whose gearing levels were more satisfactory. By the same token, some investors
might be inclined to buy the shares, whereas previously they would not have done,
because they like the new gearing level. This buying and selling of shares would be
likely to have a net adverse economic effect on the original shareholders.
Also, the uncertainty caused by the change in gearing level could make the shares
less attractive, with an adverse affect on the share price.11.9 Evidence on gearing
Some casual observations
Before going on to some of the sophisticated studies relating to gearing, it is well
worth noting some important points that arise from casual observation.
l A very large proportion of businesses have some level of capital gearing. This seems
to be particularly true among larger businesses. Few raise all of their financial
requirements from equity shareholders. Assuming that managements are pursuing‘