Gearing Flashcards
What is business risk?
The variability in earnings before interest and tax
What is financial risk?
The additional variability in returns resulting in an increased level of debt finance
What are the effect of gearing?
Cost of equity increases due to the increased financial risk. Increasing the WACC
The proportion of debt relative to equity in the capital structure increases. The cost of debt is cheaper than the cost of equity. Reducing the WACC
What is the traditional view of gearing?
Initial introduction of debt will cause WACC to fall as the increase in financial risk is outweighed by the increase of cheap debt finance
As gearing continues to increase, shareholders become more concerned due to the increase in financial risk. The increase cost of equity due to higher financial risk eventually outweighs the increase in cheap debt finance.
At Extreme levels of debt, the cost of debt will also start to rise as debt holders become concerned about the security/recoverability of their loan.
What is M&M’s 1958 view of gearing?
Level of gearing does not effect the WACC
There is no optimal level of gearing
What is M&M’s 1963 view of Gearing?
Debt finance has the tax benefit of interest being tax allowable
The WACC falls as the gearing level rises due to the tax advantage of debt finance
Geared companies will have more cash to pay out to investors so are more valuable
The optimal level of gearing is nearly 100% debt.
What are the Limitations of M&M gearing theory?
Assumes there are perfect capital markets
Doesn’t account for the increased bankruptcy risk.
Most loan agreements have restrictive covenants which limit the amount of debt finance
Tax exhaustion means that companies will have no taxable income left to offset interest charges so they will no longer achieve a tax advantage.
What are the Limitations of M&M gearing theory?
Assumes there are perfect capital markets
Doesn’t account for the increased bankruptcy risk.
Most loan agreements have restrictive covenants which limit the amount of debt finance
Tax exhaustion means that companies will have no taxable income left to offset interest charges so they will no longer achieve a tax advantage.
