Page 360 - Microsoft Word - 00 ACCA F9 IWB prelims 2017.docx

Chapter 18

The problems of high gearing

In practice firms are rarely found with very high levels of gearing. This is because of:

 bankruptcy risk (increased cash commitments on interest and redemption
payments can reduce cash balances)

 agency costs (restrictions by existing lenders on management actions)

 tax exhaustion (no tax liability left against which to offset interest charges)

 the impact on borrowing/debt capacity (no further assets on which to secure
debt reduces lenders’ willingness to lend)

 difference between risk tolerance levels between directors and shareholders
(management’s unwillingness to take risks that well diversified investors would
accept)

 restrictions in the articles of association (can specify borrowing limits)

 increase in the cost of borrowing as gearing increases (due to bankruptcy risk
and lack of assets for security)

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