Weighted average cost of capital revisited
Beattie, Goodacre and Thomson (2006) surveyed a number of UK businesses and
found that about half of the businesses had a target gearing ratio, consistent with the
trade-off theory. The other half either did not follow the trade-off theory at all, or
only partially followed it; their behaviour seemed to be consistent with the pecking
order theory.
Discussions of the two theories often suggest that they are strict alternatives;
businesses either follow one or the other. The evidence, on the other hand, suggests
that most businesses clearly follow the trade-off theory and have a target gearing
ratio that reflects each individual business’s view of the trade-off. This, however, is
often tempered, at least in the short term, by considerations that reflect the pecking
order theory.
11.13 Likely determinants of capital gearing
Having reviewed the theory and evidence on gearing, we can probably summarise the
factors that will influence a business’s decision on capital gearing. These are:
l The rate of tax.In the UK, there are clear tax advantages in paying £1 of interest on
borrowing rather than paying £1 of dividend. This will, in general, encourage debt
finance.
l Tax capacity.A tax-deductible expense has no value unless there is taxable income
against which to set it. Also, businesses with lower profits pay a lower rate of cor-
poration tax. Businesses with low earnings tend to find high gearing less attractive.
l Fluctuating sales revenue and/or high operating gearing.Either of these factors, and par-
ticularly a combination of them, can lead to severe fluctuations in the returns paid
to ordinary shareholders. This may confront the shareholders with an unacceptable
level of risk in relation to their returns. It may also increase the risk of bankruptcy
and its associated costs to the shareholders.
l Nature of the business’s assets.Businesses with assets whose value is much greater on
a ‘going concern’ than on a bankruptcy sale basis, that is, those with potentially
high bankruptcy costs, are likely to avoid high levels of gearing.
l Reluctance to issue new shares.Businesses typically feel that the market undervalues
their shares and are not eager to issue new shares at ‘undervalued’ prices. There is
also the fear that the market may perceive a share issue as a last resort, implying
that the business is in difficulties.
l Costs of raising the capital.Most equity finance comes from retaining profits. Here
‘issue’ costs are zero, whereas issues of shares, even rights issues, are relatively
expensive. Debt finance tends to be cheap to raise. Inevitably, these facts will affect
most decisions on capital gearing.
l Costs of servicing the capital.The prevailing rates of interest will also be a relevant
factor.
11.14 Weighted average cost of capital revisited
Towards the end of Chapter 10 it was said that there are two points about using
WACC that it would be better to consider now.
