Gearing
14 January 2020 13:42
Two different theories of determinants of gearing and financial decisions:
1. Trade-off theory
• Benefit of debt: tax saving
• 'Agency' benefits of debt: disciplines manager
• Main cost of debt: expected costs of financial distress
• Predictions:
○ Each company has its own target level of gearing
○ Company characteristics which favour high gearing:
▪ Company is paying corporation tax (therefore profitable)
▪ Low expected costs of financial distress (profitable, low business
risk, low proportion of intangible assets)
▪ Positive cash flows (before interest) imply more benefit from
discipline of debt
▪ Tangible assets make it easier to provide security
▪ Highly geared companies should be profitable and low risk – tend
to be mature companies
• Slow adjustment to target:
○ Factors affecting gearing are 'weak and slow'
○ At any given time, many companies will be off target
○ Slow adjustment to target implies that a cross sectional regression,
with gearing as dependent variable, will yield weak results (low R^2)
2. Pecking order
• Costly to raise external capital (because information asymmetry)
• Equity is a last resort: difficult to issue shares at fair price, transaction costs
• Source of funds: internal funds first, debt second, equity a distant third
• Predictions:
○ No target gearing: debt fluctuates over time depending on the
company's need for external funds. Changes in debt reflect cash surplus
and deficits
○ Equity issues are rare
○ Implies opaque, hard-to-value companies (risky, young, high proportion
intangible assets) should rely on debt more than equity (trade off
would suggest opposite)
3. Value of financial flexibility
, ○ Implies opaque, hard-to-value companies (risky, young, high proportion
intangible assets) should rely on debt more than equity (trade off
would suggest opposite)
3. Value of financial flexibility
• Firm may encounter a constraint in raising debt, beyond a certain amount.
• Raising equity is expensive (high fees), and is not desirable if firm believes
itself to be undervalued.
• Predictions:
○ Firm will protect its capacity to borrow:
▪ Low gearing preferred, unless external funds are needed; cash
holdings increase flexibility
○ Share issues are possible and sometimes desirable (difference from
pecking order) they help create flexibility.
Evidence
What do executives say? (Graham & Harvey, J of Financial Economics 60, 2001)
• Survey of CFOs, and interviews
• Top two concerns are financial flexibility and company's credit rating
• Support for trade-off:
○ 81% of firms have a target gearing
○ Tax advantage is NB
○ Concern about credit rating is consistent with trade-off
• Support for pecking order:
○ Flexibility is NB
○ Firms avoid issuing equity when undervalued
○ But financial behaviour is not related to asymmetric information
• Executives don’t think gearing up is used to reduce free cash
Cross-sectional regression (Frank & Goyal, Financial Management, Spring 2009)
• Big test of which factors or variables affect observed gearing at a given date
• Good discussion of theories, variables that might affect gearing, and existing
evidence
• Method:
○ Cross-sectional (panel) regression, with explanatory factors lagged by
one year:
▪ Lj,t = a + b1F1j,t–1 + b2F2j,t–1 + ... + ej,t
○ Leverage measured as Debt/(Debt + Equity)
○ Equity is either at market value (market leverage) or book value (book
leverage)
14 January 2020 13:42
Two different theories of determinants of gearing and financial decisions:
1. Trade-off theory
• Benefit of debt: tax saving
• 'Agency' benefits of debt: disciplines manager
• Main cost of debt: expected costs of financial distress
• Predictions:
○ Each company has its own target level of gearing
○ Company characteristics which favour high gearing:
▪ Company is paying corporation tax (therefore profitable)
▪ Low expected costs of financial distress (profitable, low business
risk, low proportion of intangible assets)
▪ Positive cash flows (before interest) imply more benefit from
discipline of debt
▪ Tangible assets make it easier to provide security
▪ Highly geared companies should be profitable and low risk – tend
to be mature companies
• Slow adjustment to target:
○ Factors affecting gearing are 'weak and slow'
○ At any given time, many companies will be off target
○ Slow adjustment to target implies that a cross sectional regression,
with gearing as dependent variable, will yield weak results (low R^2)
2. Pecking order
• Costly to raise external capital (because information asymmetry)
• Equity is a last resort: difficult to issue shares at fair price, transaction costs
• Source of funds: internal funds first, debt second, equity a distant third
• Predictions:
○ No target gearing: debt fluctuates over time depending on the
company's need for external funds. Changes in debt reflect cash surplus
and deficits
○ Equity issues are rare
○ Implies opaque, hard-to-value companies (risky, young, high proportion
intangible assets) should rely on debt more than equity (trade off
would suggest opposite)
3. Value of financial flexibility
, ○ Implies opaque, hard-to-value companies (risky, young, high proportion
intangible assets) should rely on debt more than equity (trade off
would suggest opposite)
3. Value of financial flexibility
• Firm may encounter a constraint in raising debt, beyond a certain amount.
• Raising equity is expensive (high fees), and is not desirable if firm believes
itself to be undervalued.
• Predictions:
○ Firm will protect its capacity to borrow:
▪ Low gearing preferred, unless external funds are needed; cash
holdings increase flexibility
○ Share issues are possible and sometimes desirable (difference from
pecking order) they help create flexibility.
Evidence
What do executives say? (Graham & Harvey, J of Financial Economics 60, 2001)
• Survey of CFOs, and interviews
• Top two concerns are financial flexibility and company's credit rating
• Support for trade-off:
○ 81% of firms have a target gearing
○ Tax advantage is NB
○ Concern about credit rating is consistent with trade-off
• Support for pecking order:
○ Flexibility is NB
○ Firms avoid issuing equity when undervalued
○ But financial behaviour is not related to asymmetric information
• Executives don’t think gearing up is used to reduce free cash
Cross-sectional regression (Frank & Goyal, Financial Management, Spring 2009)
• Big test of which factors or variables affect observed gearing at a given date
• Good discussion of theories, variables that might affect gearing, and existing
evidence
• Method:
○ Cross-sectional (panel) regression, with explanatory factors lagged by
one year:
▪ Lj,t = a + b1F1j,t–1 + b2F2j,t–1 + ... + ej,t
○ Leverage measured as Debt/(Debt + Equity)
○ Equity is either at market value (market leverage) or book value (book
leverage)
