Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
lThe pecking order for raising funds is:
1 retained profit;
2 debt finance;
3 equity issues – as a last resort.
lPecking order theory can be seen as a brake on the trade-off theory, rather
than as a strict alternative to it.
lEvidence on the pecking order theory is that it is not widely applied as the
principal financing strategy, though it can prevail in the short term.Practical issues
lMost businesses seem to use gearing, but not to very high levels.
lBusinesses with high operating gearing may be unsuitable for high capital
gearing.
lDirectors may not favour as high a level of gearing as is beneficial to share-
holders (agency problem).
lBusinesses may attract shareholders because of their gearing level (clientele
effect).
lHigh tax rates will encourage high gearing.
lTax capacity (having sufficient profit to be able to benefit from the tax relief on
interest) may well affect gearing levels.
lBusinesses may be reluctant to make share issues if they believe that they will
disadvantage existing shareholders.
lThe relative costs of raising funds (issue costs):
lEquity from retained profit – virtually nothing.
lEquity from rights or public issue – very expensive.
lDebt finance – relatively cheap.The subject of capital gearing is well written up in the literature. There is good coverage of it by
Brealey, Myers and Allen (2007), Arnold (2005) and Atrill (2009). It is worth reading the original
MM articles, which are reprinted in Archer and D’Ambrosio (1983).