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IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information

A listed company with high operational gearing in a cyclical industry is considering raising additional debt. Which statement about the effect of financial gearing on the shareholders is correct?

Higher financial gearing increases the variability of returns to shareholders, because fixed interest must be paid before equity receives anything. When combined with high operating gearing in a cyclical business, the equity risk is magnified, so the stated option is correct.

  1. AHigher gearing reduces the volatility of earnings per share because interest is a fixed cost
  2. BHigher gearing increases the variability of returns to equity holders, so combined with high operating gearing the risk of the equity is magnifiedCorrect
  3. CHigher gearing lowers the risk of equity because debt holders rank behind shareholders on liquidation
  4. DHigher gearing has no effect on equity risk if interest is tax deductible
  5. Higher gearing always lowers the weighted average cost of capital regardless of financial distress costs

Explanation

Fixed interest charges mean that changes in operating profit cause larger proportional changes in profit available to equity, and this compounds operating gearing. Debt ranks ahead of equity on liquidation, so the third option is wrong. Tax deductibility lowers cost but does not remove added risk.

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