Determinants of Capital Gearing

Submitted by: KevinB

A large proportion of firms will consider some level of capital gearing as very few firms raise all of their financial requirements via equity shareholders. This assumes that managements are actively pursuing a shareholder wealth maximization objective and presumably using gearing to achieve that objective.

Capital gearing does not account for extremely high levels by many firms as the common belief is the value of the firm is not maximized when excessive gearing levels are implemented. However, all firms will consider similar factors in determining what capital gearing ratio will best maximize shareholders' returns.

A summary of the main determinants of capital gearing which will influence a firm's decision on attaining the appropriate gearing ratio are:

1. The rate of tax: Depending on a companies taxable profit level, this will determine whether or not they would be in a position to gain from debt financing. Debt financing will occur when there are tax advantages for paying ?1 of loan interest compared to paying ?1 of dividend interest.

2. Tax capacity : for a tax deductible expense to have value, there is a requirement to have taxable income against which to set it. Consequently, companies with low earnings will tend to find having high gearing less effective.

3. Fluctuating sales: If a company has fluctuating sales, then it stands to reason that fluctuations in the returns paid to ordinary shareholders will also occur in direct relation to sales. This increases the risk to the shareholder in relation to their returns and subsequently could increase the risk of bankruptcy and overall lower the appeal for shares.

4. High operating gearing: Any company that has a high operating gearing can add risk to the shareholder returns and have a similar bankruptcy risk associated with fluctuating sales. A combination of fluctuating sales and high operating gearing will pose high risk to shareholders in general.

5. Nature of the firm's assets: Firms that have assets whose value is significantly greater as a 'going concern' than on a bankruptcy sale basis, will generally avoid high capital gearing due to the difference in value.

6. Costs of raising capital Loan finance tends to be cheap to raise although most equity finance will come from retaining profits. An issue of shares can be relatively expensive and inevitably will be a factor in a firm's decision on capital gearing.

7. Capital servicing costs One factor that cannot be overlooked when deciding on capital gearing will be the prevailing rates of interest that will be secured against any gearing decision.

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KevinB is an article researcher for various topics including Business Articles for Ad-Matrix.net article directory.

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