Shareholders and Management of companies generally agree that it is good to introduce gearing into a company’s financing structure to enhance returns to shareholders. Excessive debt and gearing above a level that a company can comfortably afford is risky.
Required:
State and explain THREE (3) main difficulties associated with highly geared companies. (6 marks)
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- High volatility to company or equity returns. The higher the level of debt, the higher the company’s level of interest cost or expense. Volatility in interest rates, especially variable interest rate debts, can cause volatility in the company’s earnings. The drops in earnings resulting from the rising interest rate environment and vice versa expose the company and shareholder returns to a high level of volatility and uncertainty.
- High debt burden and bankruptcy. The over borrowing environment can cause significant interest burden payments to the company, and where earnings are not strong enough to absorb the cost and burden, it can throw the company into an interest and principal payment distress situation leading to high bankruptcy risk and the possibility of shareholders losing the value of their investments since they will be the last to be compensated in a liquidation situation.
- Loss of market reputation and credibility. Listed stocks require a lot of disclosure, and shareholders’ and analysts can easily pick this high borrowing situation. This will begin to trigger confidence crises and challenges for the company in the market.
- Short-termism may dominate the thinking and behaviour of Management instead of long-term shareholder value maximisation. For example, the pressure to service loans on debt might shift their actions into short term activities that will create cash flows to service these facilities to avoid defaults and the consequences of that.
- Lower financial flexibility
(Any three points @ 2 marks each = 6 marks)