Traditional and Contemporary Gearing - Literature review Example

TRADITIONAL AND CONTEMPORARY GEARING By Student’s Name Code + Course Name Professor’s Name University Cite, State Date Traditional Gearing This is also termed as the traditional theory of optimal market. It assumes that there is an optimal capital structure that every company must reach. The traditional gearing method stipulates that the weighted average cost of capital (WACC) should be minimized while the market value of the assets is at its maximum level. The optimal structure is a situation that has minimal financial costs to the firm. For this level to be achieved, investors are expected to behave in a distinctive manner. For instance, a given firm can opt to achieve the aforementioned by way of taking an expensive debt with a cheaper equity structure. Analyst states that this will, in turn, help to maximize the average returns that the company will access from the business. For instance, in a case where the capital is expensive and the returns are not, it will cover for the cost capital. (Annabel, 1986) Traditional theorists like Relly (1973, p.126) argued that the step depict some benefits advantages that will decreases in the event that a firm has increased the level of gearing. Moreover, lenders will likely continue to demand from the company more premiums in relation to the debts because of the involved higher risks. At this stage, it will be upon the company to choose whether or not to move to the traditional methods of gearing or rather adopt modern methods. Some of the behavioral assumptions of these gearing methods involve the manner for which investors will perceive the risk and also, the way for which they will likely adjust the demanded interest rates from the borrowing firms. Cohen (1999, p126) summarizes that, the focus on any company should be ready to blend since it will definitely prevent a firm from matters related to over-exploitation especially in cases where investors demand for implicit and enormous levels of premium interest rates on borrowings made. Looking at a lower level gearing, equity holders will perceive the rising debt and also, costs that they are likely to incur as minimal in comparison to the degree of cheapness of debts, which exists. However, at higher levels of gearing every business is expected to act with higher degree of uncertainty in regards to manner for which the capital market is volatile towards the repayment of interest. Shannon (2010, p 43) posits that, upon the whole analysis of the company’s immediate value, it is always found out that it is affected by different levels of flexible gearing, which might be applied either higher or lower. Significantly, the immediate choice a company makes is not perceived to be important since it has the same effect on the debt equity ratio. Consequently, a company or a firm can choose any form of financing they want to pursue (Nantel, 2003). Most notably, it is important to realize that traditional method is focused on trying to expound that the weighted average cost of capital (WACC) will change in the event that the capital structure has been changed. However, it does not explain or describe the optimal level. Thus, for the traditional method to succeed it is imperative that the capital structure should be at its minimum while the market structure should hit a maximum. Effects on the Cost of Capital The effect on the cost of capital is expounded under numerous assumptions. For instance, it is argued that the increased duration of cash flow does not directly affect the cost of cash flow of capital of a firm. Consequently, it is noted that the transfer of cash from one regulatory circle to another does not accord any form of risk. Also, it is posited that after clearly measuring the WACC effects, there is no fundamental rationale behind financialbility. Notably, it is certain that a given percentage of investors are always willing to provide a firm an extra form of financing at relatively no cost. However, according to Shannon (2010, p 45) these assumptions do not hold any water since increased gearing is likely to increase the risk of exposure the firm has. Besides, increased gearing is likely to have three major effects on the cost of capital (Brick, 1978). Nantel (2003, p 1343) expounds on premium effect as being some increased sensitivity on the values of sources of cash flows in relation to possible capital intersect. For instance, it questions how sources of cash flow behave whenever the interest rates of any company goes up or down, the beta effect which will result when the sensitive of the market price of increases and also, time in-consistency effect which results whenever there are probability of some event which have not been outlined in the contract occurring to the firm’s cost of capital. From this, financial analysts have noted that there is a tendency of the cost of capital to increase as a result of the increases of gearing to a firm. Nevertheless, the assumptions have failed to analyze the aspect of optimal level. Evaluation of Modern Approaches In the modern times, the manner for which a firm’s structure is arranged postulates that there is always a relationship between aspects of fixed stock and equity distribution. For instance, a highly geared firm depicts a higher fixed interest to equity ratio. Whenever a firm decides to change its gearing, it may alter its cost of capital. Notably, uncertain circumstances may force any firm to increase the amount of its gearing. In the event that this happens it will increase the tax deductibility of the firm however; the fundamental reason why there cannot be effects at this phase rests with the assumption that there exists a primary limit of the amount of debt that a firm can borrow at any given moment (Frankfut, 2000). Financial analysts like Moses (2003, p 89) have perceived that, in the modern gearing markets, there exists a relationship between the amount of capital and equity returns. If any company replaces equity with debt, the cost of capital will be reduced by a significant amount. However, economists, on the other hand, continue to argue that equity capital depict lower costs than the traditional cost that one might be thinking of. The view that gearing can reduce the cost of capital has been the major reason for most companies engaging in the restructuring process. Hoshi (1999, p 32-40) depicts skepticism about the reduction of cost of capital that arises as result of increased leveraging. Overall, there are dissenting views on the issue of gearing and financial leverage. Although the views differ, there has not been a very good analyst of the same to come up with a conclusive factor. One of the theories that expound on this is the trade-off theory, which states that the relationship between gearing and the cost of capital will definitely be influenced by two factors. James (2002, p716) goes further to state that a higher corporate tax rate has a declining impact on WACC. Subsequently, most businesses with lower business risks often will definitely be able to sustain higher gearing level before bankruptcy is able to affect them. Douglas (1991, p 35) explains that the most important assumption of the theory states that the cost of equity will increase with an immediate increase in gearing. This is affected by the risk that shareholders have taken to finance the company. Given that they have risked a lot, they will require a higher rate of return to cater for the impending cost. The trade off theory acknowledges that there are some benefits whenever the optimal structure of capital is attained within a firm’s operations. According to Bar (1977, p211) apart from the trade off theory, the other theories, which have tried to expound on the optimal gearing, may not be correct. For instance, Miller proposed that the value level tax would not exist whenever there is the presence of both personal and the corporate taxes. He went further to explain that there are different taxes on interests of income all over the economy. Hence, as the level of debt is rising, people with higher tax rates on the debts will be attracted to the markets that have the more debt. Hence, Miller concluded this theory by saying that the cost of equity will higher. From Miller’s point of view no matter how much a firm borrows, there would not be any relation hence any benefits which could be gotten from the tax that the company pays. Since there are no changes or benefits, the capital of the company will not affect the stock market (Felix, 2013). From the theory, we can deduce that as the level of company debt increases, the return accrued to shareholders also goes up. All shareholders investing in the company will definitely demand a higher premium on their investments whenever companies have a lower proportion of debt since it lowers its WACC. Anditi (2003, p 1002) supports this by stating that in any industry there are many levels of gearing some companies given that some of them are under geared while others are over geared. However, it is likely that an efficient market structure will motivate the under geared firms to increase their level of gearing and the over geared firms to lower their level of gearing. Adrian (2013, p 24) concurs that by positing that any firm that is over geared often considers the risk of running into debts that can lead to a take-over hence they often restructure back to the optimal level. In aggregate, the overall gearing of a firm should be close to optimal level (Brick, 1978). References List Anditi, F, 2003, The Weighted Cost of Capital. Some Questions on its Definitions, The journal Of Finance 28(1): 1001-1008 Adrian, B, 2013. Long-term Investments; The cost of Capital. Journal of Dividend 2013 (1):20-32 Bar, S, 1977, Interactions of Corporate Financing and Investments. Journal of Finance 32 (2): 211-217 Baranek, W, 2000, The Cost of Capital, Capital Shareholding, and Maximization of Shareholders Wealth. Journal of Finance and Shareholding. 10(7):1-20 Brick, R 1978, Economic Life of an Investment. Journal of Financial and Qualitative analysis 56(2): 34-50 Barack, M. 2000, Cost of Capital and Traditional Gearing. Routledge Publications. Cohen, H.1999. 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Journal of Economics 89 (1):43-45 Meyers, S 1990. Interactions of Corporate Financing and Investments. Journal of Investments 29(7):1-25 Annabel, U1986, Analyzing Gearing. Towards a good Future. Journal of Business 34(40): 34- 45 Nantel, T.2003, The cost of Capital as a Weighted Average. Journal of Finance 30(23):1343- 1355 Relly, R 1973, On the Weighted Average cost of Capital. Journal of Financial and Quantitative Analysis 8(40): 126-123 Rebecca, T.1999. Corporate Diversification and The cost of Capital. Journal of Finance.68 (5): 1961-1980 Shin, H.1999, Financing Constraints and Internal Capital Markets. Journal of Corporate Finance 33(1): 169-170 Shannon, P.2010. The Cost of Capital. Applications and Examples. Wiley Publications Read More