Describing Gearing and Its Importance in Capital Structure of a Company
A company with low gearing is one that is mainly being funded or financed by share capital (equity) and reserves, whilst the one with a high gearing is mainly funded by loan capital. Now the question to address is which of the two (equity and debt) is cheaper to the company? The answer is that cost of debt is cheaper than cost of equity. This is because debt is less risky than equity and the tax advantage of debt over equity as discussed below:
Risk: debt is less risky than equity because:
• the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors;
• the payment of interest is often a fixed amount and compulsory in nature 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 shareholders as they are higher in the creditor hierarchy (the order in which creditors get repaid), as shareholders are paid out last.
Corporate 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 financing a company. However, there are implications of pursing high gearing rather than low gearing. Watzon and Head (2007) described the following as implications of high gearing:
Increased volatility of equity returns: the higher a company’s level of gearing, the more sensitive its profitability and earnings are to changes in interest rates. The company’s profit and distributable earnings will be at risk from increases in the interest rate. This risk will be borne by shareholders as the company may have to reduce dividend payments in order to meet its interest payment as they fall due. This kind of risk is referred
Risk: debt is less risky than equity because:
• the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors;
• the payment of interest is often a fixed amount and compulsory in nature 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 shareholders as they are higher in the creditor hierarchy (the order in which creditors get repaid), as shareholders are paid out last.
Corporate 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 financing a company. However, there are implications of pursing high gearing rather than low gearing. Watzon and Head (2007) described the following as implications of high gearing:
Increased volatility of equity returns: the higher a company’s level of gearing, the more sensitive its profitability and earnings are to changes in interest rates. The company’s profit and distributable earnings will be at risk from increases in the interest rate. This risk will be borne by shareholders as the company may have to reduce dividend payments in order to meet its interest payment as they fall due. This kind of risk is referred