Gearing and the Cost of Capital

It will be recalled from Part 2 that the distribution of a firm's capital structure as between share capital (equity capital) and fixed interest stock (preference shares and debentures) is known as the gearing. A firm which is highly geared has a higher ratio of fixed interest stock to equity capital. By changing its gearing, a firm may alter its average cost of capital.

It should be noted that financial theorists have argued that it is due only to the influence of a corporation tax system which allows loan interest as a tax deductible expense that gearing is of any significance.

Financial planning requires a firm to give very serious consideration to its capital structure and to its gearing. Very complex issues are involved in planning an appropriate capital structure. Circumstances may make it advantageous to attempt to increase the proportion of loan capital, that is, increase the gearing, such as the tax deductibility of loan interest which we have already mentioned. There is an upper limit to debt finance, however, for not only are there obvious dangers in the presence of large fixed interest charges against corporate income, but there are practical limits to the amount of funds which may be borrowed for long-term purposes.

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Read on: Taxation and Other Factors

In order that DCF calculations should lead to correct results, it is important that all factors affecting the calculations of cash flows should be taken into account. The most important of these factors is, of course, taxation. Indeed, we have assumed from the outset that the cash flow figures were net after tax. Apart from the direct effects of taxation, we should also adjust our figures for indirect aspects of taxation, such as investment grants, and the reader will recall that in calculating the net investment outlay, any recoveries in the form of investment incentives must be deducted from the... see: Taxation and Other Factors