Chapter 19 - The Effect Of Changes In Gearing

Question 1

What are the three theories of gearing ?

Answer 1

1. Traditional theory
2. Modigliani and millers theory of gearing
3. Pecking order theory

Question 2

What is the traditional theory ?

Answer 2

With higher gearing the cost of equity increases as the risk increases so the weighted average changes too. For example:

Equity/debt 100%/0% 80%/20%
Cost of equity 20% 22%
Cost of debt 10% 11%
Total 20% 19.8%

Gearing tends to remain constant % until high level of borrowings then it increases

The total blend is pulled down by the higher gearing

The optimum gearing is the lowest total blend and it is trail and error to find the optimum gearing, how far can you borrow debt until the cost of equity increases ?

Question 3

What are the modigliani and miller theory ?

Answer 3

They said the cost of equity will go up due to more risk but since we know what is causing the risk we can therefore calculate how exactly shareholders will react and how cost of equity will change

They found will higher gearing, the equity increased in a very precise way.

They found weight average cost of capital would stay constant. Therefore no such thing as optimum level

Question 4

What were the assumptions made by Modigliani and miller

Answer 4

1. Shareholders have perfect knowledge
2. Shareholders act rationally with regards to risk
3. A perfect market exists (ignores transaction fees for share purchase)
4. Debt interest is tax allowable (and company is making profit to allow for the tax allowance)
5. Investors are indifferent between corporate gearing and personal gearing
6. The debt borrowing is irredeemable ( usually it is redeemable)

Question 5

What is pecking order theory ?

Answer 5

Companies should raise money in the easiest possible way, the order of easiest to hardest is below

1. Retained earnings
2. Straight debt
3. Convertible debt
4. Preference shares
5. Equity shares