The paper “ Traditional and Contemporary Gearing” is an outstanding example of a literature review on finance & accounting. This is also termed as the traditional theory of the 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. The 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 the cost capital. (Annabel, 1986)Traditional theorists like Relly (1973, p. 126) argued that the step depicts 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 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 the cheapness of debts, which exists.
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