Capital Structure and Gearing

Capital Structure & Gearing

• Gearing refers to financing with debt.
• Financing with debt is typically cheaper than equity.
• Firms avoid high gearing due to the risk of financial distress.

Gearing Levels and Financial Risk

• At low gearing levels, the risk of financial distress is low, but the cost of capital is high.
• At high gearing levels, the opposite occurs: higher risk of financial distress, lower cost of capital.
• The overall cost of finance is high at low gearing and low at high gearing, assuming constant returns to equity not rising with gearing.
• The risk of a company becoming financially distressed is low at low gearing and high at high gearing.

Operational and Financial Gearing

• Operational gearing is the extent to which a firm's total costs are fixed.
• Financial gearing is the proportion of debt in a company's capital structure.
• Capital gearing is the extent to which a firm's total capital is in the form of debt.
• Income gearing is the proportion of annual income devoted to paying debt (interest).

Capital Gearing Formulas

• Capital Gearing (1) = (Long term debt) / (Shareholders funds)
• Capital Gearing (2) = (Long term debt) / (Long term debt + shareholders funds)
• Capital Gearing (3) = (All borrowings) / (All borrowings + shareholders funds)
• Capital Gearing (4) = (Long term debt) / (Total market capitalization)

Income Gearing Formulas

• Interest cover = (Profit before interest & tax) / (Interest charges)
• Income gearing = (Interest charges) / (Profit before interest & tax)

Effects of Gearing

• Gearing leads to higher risk.
• Business risk is the variability of a firm's operating income due to general business risk and economic conditions.
• Financial risk is the additional variability in return to shareholders because the financial structure contains debt.
• With high operating profits, shareholders in a geared firm will experience a more than proportional boost in returns compared to those in an ungeared firm.
• Business risk is the variability of the firm's operating income (income before interest).
• Financial risk is the additional variability in returns to shareholders because the financial structure contains debt.

Factors Impacting Gearing Level

• Financial distress
  • Sensitivity of company's revenues to the general level of economic activity
  • Proportion of fixed to variable costs
  • Liquidity and marketability of the firm's assets
  • Cash generative ability of the business

Other Considerations Impacting Gearing Level

• Agency costs
• Borrowing capacity
• Manager preference
• Pecking order
• Financial slack
• Signaling
• Control
• Industry group gearing

Costs of Financial Distress

• Indirect costs include uncertainties in customers' and suppliers' minds, low prices for quickly sold assets, delays and legal issues with financial reorganization, excessive emphasis on short-term liquidity, selling healthy businesses, and loss of staff morale.
• Direct costs include lawyers', accountants', and court fees, as well as management time.

Factors Influencing the Risk of Financial Distress Costs

• Sensitivity of revenues to economic activity
• Proportion of fixed to variable costs
• Liquidity and marketability of assets
• Cash-generative ability of the business

Business Characteristics and Gearing

• Food retailers are relatively insensitive to economic fluctuations, have mostly variable costs, easily sold assets (Shops, stock), and a high or stable cash flow. It's likely acceptable gearing ratio is high.
• Steel producers are dependent on general economic prosperity, have mostly fixed costs, assets with few alternative uses/thin secondhand market, and an irregular cash flow. It's likely acceptable gearing ratio is low.

Agency Costs

• Agency costs include the direct/indirect costs of ensuring agents act in the best interest of principals.
• Agency costs for lenders
• Information asymmetry
• Lenders require a premium on debt interest to compensate for monitoring costs.
• Restrictions (covenants) are built into lending agreements.
• Psychological element; managers dislike restrictions.

Additional Factors in Debt Finance

• Borrowing capacity
• Managerial preferences
• Financial slack
• Signalling
• Control
• Industry group gearing
• Motivation
• Reinvestment risk
• Operating and strategic efficiency

Pecking Order Theory

• Firms prefer to finance with internally generated funds.
• If more funds are needed, the debt market is used next.
• As a last resort, companies raise equity finance.
• Myers (1984) stated there is no well-defined target debt-equity mix because there are two kinds of equity: internal and external.
• Stock markets perceive an equity issue as a sign of problems or desperation.
• Adverse selection problem
• Shares are more expensive to issue than debt capital, which is more expensive than using previously generated profits.