If a company wants to use equity or debt in financing its operations, the following should be considered:
1. The cost of debt capital. Tax relief is available to companies on interest costs, but not on dividends. Debt capital is therefore cheaper than equity, and is consequently often preferred by management.
2. The board of directors might try to keep gearing within a target range that shareholders and lenders might regard as ‘normal’ or ‘acceptable’ for the company.
3. Gearing policy might be affected by board policy on retained profits. When retained profits are fairly high, a company might have little recourse to external financing, and so would have a very low gearing level.
4. Gearing might be influenced by management’s views on interest rates. Borrowing might be avoided when market interest rates are considered high, or in the case of variable rate borrowing if interest rates are expected to rise.
Long-term and short-term debt
i. The traditional view is that fixed assets should be financed by long-term sources of finance and current assets by a mixture of long-term and short-term sources. If a company finances illiquid assets from short-term debt it faces the risk of insolvency in the event of its being unable to renegotiate the loans when they fall due.
ii. Transaction costs vary according to the type of finance being raised. For example, it will
iii. be cheaper to arrange a medium-term bank loan than a public issue of dated loan stock. Short-term debt will need to be renegotiated more frequently and this will give rise to recurring transaction costs.
iv. The relative interest rates carried by long-term and short-term debt will vary over time according to supply and demand and to market expectations of interest rate changes. Rates are generally higher on long-term loans than on short-term since the level of risk faced by the lender that interest rates may rise before repayment is due is higher.
v. The company may find it easier to raise short-term finance with low security than long-term finance.
vi. In opting for short-term debt, the company faces the risk that it may not be able to renegotiate the loan on such good terms, or even at all, when the repayment date is reached. Long-term loans are thus less risky.
vii. Long-term debt may carry early repayment penalties if it is found that the loan is no longer needed or a more attractive form of finance becomes available. Short-term debt is more flexible since it allows the firm to react to interest rate changes and to avoid being locked into an expensive long-term fixed rate commitment at a time when rates are falling