Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
other words, the greater the value of the tax shield, the higher the level of debt. They
also found that larger businesses tend to be more highly geared than smaller ones, per-
haps reflecting the greater ease with which larger businesses are able to raise external
finance. These tax and size points were confirmed by Ozkan (2001), using UK data. He
also found evidence that businesses have a target gearing ratio that they try to return
to quickly when they diverge from it. He inferred from the fact that they returned to
the target quickly that the costs of being away from their optimal gearing position
were significant. Eriotis, Vasilou and Ventoura-Neokosmidi (2007) found, based on
analysis of 129 businesses listed on the Athens Stock Exchange, that larger Greek busi-
nesses tend to have higher levels of capital gearing.
Graham and Harvey (2001) found that, among the US businesses that they sur-
veyed, the tax benefit of debt finance is seen as an important factor in capital gearing
decisions. This is particularly true among larger businesses where the tax rate is
higher. They also found that businesses did not see the potential costs of bankruptcy
as being an important issue, except for those businesses that were already relatively
financially weak. On the other hand, many businesses were concerned about the credit
rating of their debt (AAA, AA etc). This may indicate a concern about financial dis-
tress. Graham and Harvey also found that only 19 per cent of businesses had no tar-
get gearing ratio, although some of those that did had a fairly flexible one.
The formal evidence seems to answer the first question above: WACC decreases
with increased gearing. It does not really deal with the second question, and so we do
not know from the formal evidence whether or not WACC bottoms out at some point
below 100 per cent gearing, after which it starts to increase.
Kester (1986) found dramatic differences between industrial sectors as regards
levels of gearing. The highest average level of gearing was found in steel manufacturers
(where debt was 1.665 times the market value of equity). The lowest occurred in phar-
maceutical manufacturers (where the debt was only 0.097 times the market value of
equity). It is not clear why there should be such differences, or why these two indus-
tries should occupy the positions indicated. One theory concerns the potential costs of
bankruptcy. Some industries can liquidate their assets more easily than can others,
with less difference between the value of the assets to the business on a ‘going concern’
basis and on a bankruptcy sale basis.
There also seem to be international differences in gearing levels. McClure, Clayton
and Hofler (1999) looked at gearing levels in all of the G7 group of ‘rich’ industrial
countries in 1991. They found that, by market value, debt to total value in the UK aver-
aged 40.7 per cent. This contrasted with an average for all G7 countries of 45.1 per cent
and quite wide variations between individual countries. These differences can prob-
ably be explained by international differences. For example, high corporate tax rates
would tend to encourage borrowing; the UK has relatively low tax rates. Also, bank
financing is more traditional in some countries than in others: for example, it is more
so in Germany than in the UK.11.10 Gearing and the cost of capital – conclusion
The central question on gearing is whether in reality it is the traditionalists or MM
who best explain the effect of gearing.
The traditional view, that somehow equity shareholders do not pay much attention
to the increased risk that rising amounts of gearing engender until it reaches high