Week 6 - Gearing And Valuation Of Assets

Question 1

Define Gearing

Answer 1

Gearing is the ratio of how much debt a firm has to the total of its equity and debt

Question 2

What is formula for Gearing?

Answer 2

Gearing (%) = debt / (debt + equity)

Question 3

What are the differences between borrowing from shareholders and borrowing from the bank? (4)

Answer 3

• It is cheaper to borrow from the bank than from shareholders but excessive bank borrowing can make shareholders concerned that they will not receive a dividend
• The more you borrow from the bank the higher geared you are
• Banks must be repaid with interest added on top
• Banks have no control but shareholders can gain control of a company

Question 4

What is the impact of excess debt (if gearing gets too high) (2)

Answer 4

• Repayment risk - risk to bank increases as their is less of an equity buffer to absorb loses that the business may make
• Interest risk - interest cost must be met before dividends are paid to shareholders and if it cannot be paid banks can exercise their rights to force repayment through asset sales

Question 5

What does traditional theory say about low level of gearing? (2)

Answer 5

• At low levels of gearing if a firm raises more debt then the increased risk to the shareholder is small due to the debt being cheaper than equity
• This results in WACC falling leading to the returns per share outpacing the increase in risk and the share price increasing

Question 6

What does traditional theory say about increasing gearing?

Answer 6

As gearing increases risk to shareholders increases more quickly causing the cost of equity to rise quickly outpacing the increasing profit per share causing share price to fall

Question 7

According to traditional theory gearing where is the optimum point? (2)

Answer 7

• Optimum is where cost of equity outpaces the increasing profit per share causing the share price to fall
• Although this point can differ depending on the firm the more stable the firm’s profits the higher the gearing which is optimum

Question 8

Interpret this graph representing traditional theory (9)

Answer 8

Kd cost of debt
- Initially, the cost of debt is low because banks and lenders see the firm as a low-risk borrower
- As gearing increases, debt becomes riskier, and banks chase be higher interest rates causing the cost of debt to rise slightly

Ke (cost of equity)
- At low gearing levels, shareholders face low financial risk, so they demand a lower return.
- As debt increases, financial risk rises, making equity riskier.
- Equity investors demand a higher return to compensate for the risk of higher debt levels.
- Causing cost of equity to increase sharply

K0 (WACC)
- Initially, WACC declines because debt is cheaper than equity, and adding some debt lowers the overall cost of capital.
- At the optimal gearing level, WACC reaches its minimum point—this is the ideal mix of debt and equity for maximizing firm value.
- Beyond this point, WACC rises as the increasing cost of equity and higher interest rates on debt outweigh the benefits of cheap debt.