Capital Structure and Gearing
Financing Decisions
Capital Structure and Gearing
Syllabus tag: KASNEB CPA | Intermediate Level | CA22 Financial Management | Topic 4 Capital Structure and Gearing
Lesson objectives
By the end of this topic, you will be able to:
- Measure gearing on both the common bases and say which you have used
- Compute and interpret interest cover
- Show the effect of gearing on earnings per share
- Find the EBIT indifference point between two financing options
- Outline the Modigliani and Miller propositions, with and without tax
- Explain why real companies stop short of very high gearing
Why this matters
Cost of Capital took the mix of debt and equity as given. This topic asks whether that mix should change, and what happens to the shareholders if it does.
Words to know
- Gearing — the proportion of a company financed by debt.
- Financial risk — the extra volatility in shareholder returns caused by fixed interest payments.
- Business risk — the volatility that comes from the trade itself, regardless of financing.
- Interest cover — how many times profit covers the interest bill.
- Indifference point — the EBIT at which two financing options give the same EPS.
Measuring gearing
Two bases are in common use, and they give different numbers.
Debt 400m, equity 600m:
- Debt to capital employed: 400 / 1,000 = 40%
- Debt to equity: 400 / 600 = 66.67%
Neither is wrong. Both are wrong if you do not say which you used, because a reader cannot tell 40% from 66.67% apart without being told the basis.
Interest cover
Interest cover = EBIT / Interest
EBIT 900,000, interest 150,000: cover = 6 times.
Lenders watch this more closely than the balance sheet ratio, because it is about ability to pay rather than about accumulated amounts. Cover below about 3 times starts to worry a bank; below 1 the company is not earning its interest at all.
The effect of gearing on EPS
A company needs KES 4 million. Compare two ways of raising it. EBIT is 800,000 and tax is 30%.
Option A — all equity. 1,000,000 shares in issue.
| KES | |
|---|---|
| EBIT | 800,000 |
| Interest | nil |
| Profit before tax | 800,000 |
| Tax at 30% | (240,000) |
| Earnings | 560,000 |
| EPS | 0.56 |
Option B — 600,000 shares plus KES 4m of 10% debt.
| KES | |
|---|---|
| EBIT | 800,000 |
| Interest | (400,000) |
| Profit before tax | 400,000 |
| Tax at 30% | (120,000) |
| Earnings | 280,000 |
| EPS | 0.47 |
At this level of profit, borrowing makes shareholders worse off. Interest takes half the EBIT, and the smaller share count does not make up for it.
The indifference point
Gearing does not always hurt. Find the EBIT at which both options give the same EPS:
EBIT × 0.7 / 1,000,000 = (EBIT − 400,000) × 0.7 / 600,000
0.6 × EBIT = EBIT − 400,000, so EBIT = KES 1,000,000
Checking, both options give EPS of 0.70 at that level.
The rule this gives you: above the indifference point gearing raises EPS, below it gearing lowers EPS. With EBIT of 800,000 the company sits below 1,000,000, which is why Option B looked worse.
:::checkpoint A company expects EBIT of 1.4 million but admits the figure could easily fall to 700,000 in a poor year. The indifference point is 1 million. Should it gear up? Set out the argument on both sides. :::
Modigliani and Miller
Without tax. In a perfect market, the value of a company is unaffected by how it is financed. Cheaper debt is exactly offset by the higher return equity holders demand once financial risk rises, so WACC stays flat. Equity 70% at 18% and debt 30% at 9% gives a WACC of 15.3% — and it would still be 15.3% at any other mix.
With tax. Interest is tax deductible, which is a real transfer of value from the tax authority to the company:
Vg = Vu + Dt
An ungeared company worth KES 5 million taking on KES 2 million of debt at a 30% tax rate is worth 5m + 600,000 = KES 5.6 million.
Taken literally this says gearing should be as high as possible, which no company does.
Why real companies stop short
Three reasons the pure tax argument does not survive contact with practice:
- Financial distress. As gearing rises, so does the chance of not meeting interest. The costs of that — lost customers, forced asset sales, legal fees — grow faster than the tax saving.
- Agency costs. Lenders impose covenants that restrict what management may do, and those restrictions carry a real cost.
- Loss of flexibility. A company already at its borrowing limit cannot fund an opportunity when one appears.
The practical result is a trade-off: an optimal range of gearing where the tax benefit still outweighs the distress cost, rather than a single precise optimum.
:::checkpoint Two companies in the same industry have identical EBIT. One is ungeared, the other is 50% geared. In a year when EBIT falls by 20%, whose EPS falls further, and why? :::