Give examples of possible costs associated with a high level of gearing. (ii) Discuss how such costs might influence the capital structure of the following.(1) A medium sized electronic company entering the home computer market and(2) An established company owning and managing a chain of hotels

Give examples of possible costs associated with a high level of gearing. (ii) Discuss how such costs might influence the capital structure of the following.(1) A medium sized electronic company entering the home computer market and(2) An established company owning and managing a chain of hotels

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter3: Evaluation Of Financial Performance

Section: Chapter Questions

Problem 21P

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Question

Give examples of possible costs associated with a high level of gearing.
(ii) Discuss how such costs might influence the capital structure of the following.
(1) A medium sized electronic company entering the home computer market and
(2) An established company owning and managing a chain of hotels

Expert Solution

Step 1

Gearing: It is a relationship between the company’s debt & equity. It shows the proportion of different sources of capital in the company.

Step 2

Possible costs associated with high gearing level:

Loan costs: This cost occurs when the market interest rates change which leads to higher loan costs to the company. These additional costs come as a burden for the company.
Interest costs: High debt of a company will lead to high-interest payments to the debtholders. High-interest payments are the costs & can be a burden to the company.
Tax costs: This cost occurs due to changes in the legislative framework like a decrease in tax benefits or an increase in tax rates.

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