Describing Gearing and Its Importance in Capital Structure of a Company

A guild with low gearing is one that is mainly being funded or financed by share big(p) ( justness) and reserves, whilst the one with a high gearing is mainly funded by loanword capital. Now the question to address is which of the two ( fair play and debt) is cheaper to the beau monde? The answer is that cost of debt is cheaper than cost of equity. This is because debt is less questioning than equity and the tax revenue advantage of debt over equity as discussed below Risk debt is less violent than equity because the required return needed to redress the debt investors is less than the required return needed to compensate the equity investors the payment of stakes is often a fixed amount and compulsory in reputation and it is paid in priority to the payment of dividends in the event of a liquidation, debt holders would receive their capital repayment before shareowners as they are higher in the creditor hierarchy (the order in which creditors get repaid), as shareholders a re paid out last. Corpo set out tax advantage in the income statement, interest (on debt) is subtracted before the tax is calculated thus, companies get tax relief on interest.However, dividends (on equity) are subtracted after the tax is calculated therefore, companies do not get any tax relief on dividends. From the above discussion, we can observe that debt is cheaper than equity when finance a go with. However, there are implications of pursing high gearing rather than low gearing. Watzon and Head (2007) exposit the following as implications of high gearing Increased volatility of equity returns the higher a fraternitys take aim of gearing, the more sensitive its profitability and earnings are to changes in interest rates.The companys profit and distributable earnings will be at assay from increases in the interest rate. This hazard will be borne by shareholders as the company may maintain to reduce dividend payments in order to reach its interest payment as they fall due. This kind of risk is referred to as financial risk. The more debt the company has in its capital grammatical construction, the higher will be its financial risk. Increased possibility of bankruptcy at very high levels of gearing, shareholders will start to face bankruptcy risk.This is defined as the risk of a company failing to meet its interest payments commitment and hence putting the company into liquidation. This is because interest payment may become unsustainable if profits decrease or interest payments on variable rate debt increase. Reduced credibility on the stock exchange at a very high level of gearing, investors will be reluctant to buy the companys shares or to offer further debt. The boost of short-termist behaviour in order to prevent bankruptcy, managers may focus on the short-term need to meet interest payment rather than long term objective of wealth maximisation.Effects of capital gearing upon WACC, company order and shareholder wealth The capital structur e of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Some companies could be all-equity-financed and have no debt at all, whilst others could have low levels of equity and high levels of debt. The decision on what mixture of equity and debt capital to have is called the financial backing decision. The financing decision has a direct effect on the burthen average cost of capital (WACC).The weighted-average cost of capital (WACC) represents the overall cost of capital for a company, incorporating the costs of equity, debt and preference share capital, weighted according to the similitude of each source of finance within the business (Cornelius, 2002). The weightings are in proportion to the market values of equity and debt therefore, as the proportions of equity and debt vary so will the WACC. Therefore the prime(prenominal) major point to understand is that, as a company changes its capital structure (i. . varies the mixture o f equity and debt finance), it will automatically import in a change in its WACC. It is important to notational system that the financing decision (i. e. altering the capital structure) affects the overall objective of maximizing shareholder wealth. This is based on the nation that wealth is the present value of future cash flows discounted at the investors required return. The market value of a company is equal to the present value of its future cash flows discounted by its WACC.It is fundamental to note that the lower the WACC, the higher the market value of the company, and vice versa. Therefore, a change in the capital structure to lower the WACC can then increase the market value of the company and thus increase shareholder wealth. As a result, the search for optimal capital structure becomes the search for the lowest WACC, because when the WACC is minimized, the value of the company and shareholder wealth is maximized. Hence, it is the responsibility of finance managers to find the optimal capital structure that will result in the lowest WACC.