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What is Capital Gearing?

Peter Bird
Published online: 28 Feb 2012.

To cite this article: Peter Bird (1973) What is Capital Gearing?, Accounting and Business Research, 3:10,
92-97, DOI: 10.1080/00014788.1973.9729005

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 92
What is Capital Gearing?
Peter Bird
It is surely a sign of the immaturity of finance as an
academic discipline that there is no generally accepted
definition or measurement formula for capital gearing
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(financial leverage). When engineers talk about gear-
ing or leverage they all know what these terms mean
and how to measure and communicate the degree of
their presence. In financial reporting there is a school
of thought which holds that diversity indicates the
presence of lively intellectual activity, while uni-
formity of definition and practice discourages and
hinders the exercise of professional judgement and
slows down the improvement of standards. In my
opinion the balance of factors is in favour of uniform-
ity in financial reporting; but it is much more clearly
and heavily in favour of uniformity in the context of
financial analysis of topics such as corporate financial
structure.
There are two quite distinct reasons for seeking
standardised usage in such contexts. First, if a
concept does not have a single recognised meaning
and measure, discussion becomes at best laborious, at
worst confused and misleading. The term cannot be
used as a known ‘codeword’, but needs to be explained
at length. If such explanations are not included, there
may be in the ensuing discussion no genuine meeting
of minds at all. Secondly, acceptance of an array of
alternative definitions and measures will tend to
reduce the incentive to seek the “best” alternative.
Such a search may show that different definitions are
most appropriateto various situations; what is thought
“best” at one time may be superseded by some other
measure in the light of later analysis; but the quest for
the optimum will improve the rigour and clarity of
thinking about the topic.
I shall support the first of these general asser-
tions by showing the effectthat confusion about capital
gearing has had on the exposition of the “arbitrage
proof” of Modigliani and Miller’s Proposition 11:
IF. Modiglani and M. H. Miller, “The Cost of Capital,
Corporation Finance, and the Theory of Investment”,
American Economic Review, June 1958,and in S. Archer
and C. A. D’Ambrosio, The Theory of Business Finance,
Collier-Mamillan, 1967, page 132 (page references to
Archer and D’Ambrosio).
A C C O U N T I N G A N D B U S I N E S S RESEARCH
“the market value of any firm is independent of its
capital structure and is given by capitalising its
expected return at the rate I?, appropriateto its class”.
This example is chosen not so much for any inherent
importance it may have, but because it has seemed to
me to be (whatever one’s view of the reality of its
assumptions or the empirical support for it) a model
of the sort of rigour to which we should all be aspiring
in financial analysis, and because it has been expound-
ed and criticised by so many other writers in a fairly
short period.
All writers seem to agree that a firm is said to be
‘geared’ or ‘levered’ if some of its capital is entitled to
a iixed periodic payment in priority to any payment to
the equity shareholders, and ‘ungeared’ or ‘unlevered’
if all of its capital is provided on equity terms. It is
also generally recognised that the variability of income
attributable to equity shareholders in a geared
company is greater than that of their income in an
ungeared company with the same operating results.
Modigliani and Miller (MM henceforth) sought to
show that whenever the market value of a geared and
an ungeared company, otherwise identical, was not
the same (as their Proposition I asserted it would be),
investors could, by engaging in “arbitrage” which
would bring the market values into equality, increase
their income while keeping the same level of gearing
as before. The last condition is vital to the original
MM proof since individual share-holders may take
widely differing views of the quality of equity income
subject to various levels of gearing.
And so ‘gearing’ must be measured. MIM do not
explicitly state how they measure gearing, but their
definition of it is entirely clear and is consistently
used in their original exposition. They measure gear-
ing as the proportion of the market value of the total
capital (of a firm or an investor) which is provided on
fixed terms as opposed to equity terms. They then
show that an investor owning the fraction a of the
shares of a geared company “2” which has shares of
total market value S, and debt capital of total market
+
value D, (S, D, = V,), can sell his shares for S,,
borrow a D, and invest these two sums in an other-
 S P R I N G 1973 93
wise identical ungeared company c ‘ ~ ” , whose total upon by themselves and MM. The investor holds
market value of shares is S = V,. He now has income 1,000 shares in Geared Ltd. (G. Ltd.), until he
switches to Ungeared Ltd. (U. Ltd.). Both have
,
of “equivalent leverage” of Y = a-v2 X - r a D,
Vl
annual incomes before interest of &IOO,OOO and their
market values are :
instead of Y, = a x - r aD, where X = operating
Geared Ltd. 8 ~ , o o oLI shares
income of each company before interest, r = the rate
of interest on debt. As long as V, > V, the investor at &I.IO 880,000
200,000 &I 6%
can increase the amount of income of “equivalent
debentures at L1-00 200,000
leverage” by making the switch of investments from
firm “2” to firm “I”. 1,080,000
,
But Y is only of “equivalent leverage” to Y if the Ungeared Ltd. ~,ooo,ooo &I shares
measure of gearing used by MM is accepted as the
shares at EI 1,-,000
only or the most sensible measure to apply in such a
situation. A review of the secondary sources, where The investor sells his 1,000 shares in G. for &I,IOO,
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writers have attemped to explain MM’s proof, often borrows and invests &1,375 in U. Ltd. Merrett
with arithmetic examples to supplement MM’s and Sykes do not say how they arrived at the figure of
algebra, is enough to show that this cannot be taken
1,000
for granted. &275. It is certainly not a D, which is -
800,000
Durand,2 in a comment on MM’s article, gives a
numerical example of switching from the geared x 200,000 i.e. A;250. Unfortunately &275 could be
Closecorp to the ungeared Petrolease, and borrowing reached from two plausible calculations. They could
on personal account to restore the investor’s gearing be following Durand; as debt interest in G. Ltd.
to the previous level. Because half of Closecorp’s absorbed 12% of its income (6% of ~200,000out of
operating income is absorbed by debt interest, he income of &IOO,OOO) then debt interest on personal
recommends borrowing an amount such that debt borrowing should absorb 12% of income from
interest will absorb half the income from Petrolease investment in U. Ltd. At A275 borrowing
shares purchased with the proceeds of Closecorp this is achieved; income from U Ltd., is
shares and the borrowed funds. This gives increased
.
income “with no loss of stability: . . the investor E I ,000,ooo x IOO,OOO = L137-50, and debt interest is
assures himself that his net income will exhibit exactly
the same percentage fluctuations as Closecorp divi- 6% of &275 = k16-50. But the statement that “h4M
dends.”3 He recommends borrowing $34,000, but assume investors to be able to borrow identical pro-
M M ’ s aD, is $30,000. It will be shown that there are portions to firms at identical interest rates”6 seems to
only two major classes of measure of gearing, and that point rather towards the other possible basis for &275
Durand’s measure comes from the class not adopted borrowing. The ratio &I,IOO equity: &275 borrowing
by MM. Yet Durand does not appear to have been is the same as the ratio of the book amounts of equity
taken to task for this by MM in their reply to his and debt in G. Ltd.
comments. Quirin7 gives yet another illustration, which has
Merrett and Sykes measure gearing as the “ratio of little connection with the original proof it purports to
debt to debt plus equity at current market values”4 be expounding. An investor owns I / ~ O O of the shares
when they are discussing the “traditional” view of in a geared company (B), and so “he must bear 1/500
a U-shaped weighted average cost of capital as “gear- of the risk of fluctuation in B’s income”. When he
ing” is increased. This is another way of stating the switches he borrows personally enough to enable
measure used by MM in their proof. But when him to buy 1/5oo of the shares in the ungeared
Merrett and Sykes set out a numerical example of company (A) “so that his risk would be unchanged”.
MM arbitrages they do not use the measure agreed In MM terminology he borrows ( a s , -a S,) and
switches from holding a s , to holding as,. In fact
this example shows not only an increase in income
ZD.Durand, “The Cost of Capital, Corporation Finance after the switch from $1,400to $1,520, but a fall in
and the Theory of Investment: Comment”, American D
Economic Review, September 1959, and in S. Archer and gearing measured in capital terms (-) from 45% to
C. A. D’Ambrosio, op. cit., pages 160-176. V
Ubid, page 164.
4A. J. Merrett and A. Sykes, The Finance and Analysis of 6Ibid, page 415.
Capital Projects, Longmans, 1963, page 396. 7G. D. Quirin, The Capital Expenditure Decision, Irwin,
SIbid, pages 413-416. 1967, pages 127-9.
 94
rD
407; and in income terms (-) from 30% to 247;.
X income and the latter seems more relevant to the proof.
And so the full power of this demonstration is not
brought out in Quirin’s text where he insists that the
investor’s risk is unchanged by the switch.
Quirin seems to have anticipated Heins and
Sprenkle8 who set out algebraically the same proof as
answer to an objection raised to the original MM
proof that, where Y is greater than Y,, the variance
of Y is greater than the variance of Y 2, Replying to
Heins and Sprenkle, MM9 accept the new proof, but
not the objection it was designed to overcome. Since
the variance of X is the same in both firms by defini-
tion, higher returns can be obtained from investment
in the lower valued firm whatever admissible value is
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taken by the random variable X.
MM do not mention the term “leverage” in this
reply or in connection with a further alternative proof
set out in the same article, which they claim to be
easier to understand and more general than either of
the previous ones. This proceeds as before to the
selling of geared equity for aS, and the borrowing of
aD,. But instead of showing that income is increased
if the whole of U S , + aD, = aV, is invested in
shares of company “I” where V2>V1, they show that,
by purchasing US = aV of the ungeared equity the
investor can obtain “the identical (random) outcome
for a smaller net investment”. Income will still be
aX - urD, as before the switch and the investor will
-
have spare cash of a(V, V,).
In Van Horne’s numerical example of this proof10
the market values of the two companies are :
A Shares $I0O,000
B Shares $77,272
5% loan stock at 100 30,000
$107,272
The income before interest of both companies is
$10,000.An investor holds 1% of the shares of B (i.e.
US,). He sells these for $772-72and borrows aD, =
1% of $30,000 = $300. As usual the basis for the
amount of borrowing is not explicitly stated. It gives
the investor the same proportions of debt and equity
in his funds as he held previously through the geared
company; but it also retains the same absolute amount
*A. J. Heins and C. M. Sprenkle, “A Comment on the
-
Modigliani Miller Cost of Capital Thesis”, American
Economic Review, 59, September 1969,pages 590-59,.
9F. Modigliani and M. H. Miller, “Reply to Heins and
Sprenkle”, American Economic Review, 59, September
1969,pages 592-595.
1OJ. C. Van Home, Financial Management and Policy,
2nd edition, Prentice Hall 1971,pages 212-214.
A C C O U N T I N G A N D B U S I N E S S RESEARCH
of prior charge deductions from his share of gross
But he then buys aS, for $1,000to produce the same
income pattern as his investment in company B -
$100of income before interest payments, $15 of inter-
est payments, $85 of income for the investor. He has
$72‘72surplus cash at the end of these deals; he has
the same degree of gearing using calculations of
percentage of gross income absorbed by interest pay-
ments. But he does not have the same degree of gear-
ing of his investment based on the capital measure
used to calculate the amount to be borrowed. Before
D for his investment was - 300 = 28%.
the switch, -
V 1072.72
300
but afterwards it was - = 30%. If the $72.72
1,000
surplus is regarded as earmarked for ungeared invest-
ment of equivalent risk it can be included in V and so
the market value measure of gearing is unchanged;
but the generality of this proof demands that “it
requires no assumption as to how the saving achieved
by switching portfolios is to be invested (or, indeed,
as to whether it be invested at all).”
Robichek and Myers11 expound M M s original
proof correctly; in the circumstances this seems
worthy of being put on record.
The second general assertion at the beginning of
this paper was that the search for a “best” definition
and measure of gearing should be encouraged and
that we should not be content with the present diver-
sity of usage, even if it did not produce the sort of
confusion which has been shown to exist. What then
are the alternative measures of leverage and what are
the choices to be made?
Two uses of the term ‘leverage’ in a financial con-
text should be noted, but they seem to be separable
from the present topic of capital gearing and can be
omitted from subsequent discussion. “Operating
leverage” has been used to describe the relationship
between the percentage change in profit and the per-
centage change in volume; in the presence of fixed
costs this is greater than unity, as illustrated by break-
even analysis and charts.12 And in public finance the
term “fiscal leverage” reflects the fact that an increase
in government expenditure tends to be more expan-
sionary than an equal increase in net government
receipts is restrictive.13 The mechanical metaphor
~ ~~~~
11A. A. Robichek and S. C. Myers, Optimal Financing
Decisions, Prentice Hall, 1965,pages 21 and 24-25.
1ZJ. C. Van Horne, op. cit., pages 679-687.
13R. A. and P. B. Musgrave, “Fiscal Policy”, in R. Caves
and Associates, “Britain‘s Economic Prospects”, Brookingsl
Allen and Unwin, 1968, pages 40-42 and Appendix Section
IV.
 S P R I N G 1973
seems of doubtful validity in this latter usage.
There is general agreement that capital gearing or
financial leverage is measured by relating character-
istics of prior charges and of the equity interest. There
are three points of decision in converting this agreed
base into an operational measure:
(a) What is included in prior charges?
(b) What characteristics of the equity interest and
of the priority sources of finance .are to be
compared ?
(c) What particular arithmetic form should the
presentation of the comparison take?
Westwick asserts14 that “the general rule followed
by writers is to limit their definition of ‘prior charges’
to preference shares and debentures” and advocates
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instead inclusion of all liabilities including trade
creditors and contractual obligations under leases and
rental agreements. Archer and D’Ambrosiols and
Marrisl6 adopt this basis at least as far as balance
sheet items are concerned. Midgeley and Burns17
include overdrafts in their prior charges. The state-
ment of Van Horne that “leverage may be defined as
the employment of an asset or funds for which the
firm pays a fixed cost or fixed return”l8 also implies
this all-inclusive coverage. Only Westwick identifies
the corresponding income effects that should also be
taken into account.19 It is necessary to agree upon a
definition of prior charges or debt capital if we are to
attain standardisation of practice. But it is not neces-
sary in order to avoid confusion in the proof of MM’s
Proposition‘ I; their debt can be represented by a
symbol or a number without precise agreement on the
items included in it.
There are three main alternatives for character-
istics of debt and equity to be compared in a measure
of gearing:
(i) capital amounts at book values
(ii) capital amounts at market values
(iii) division of income before interest payments.
The first of these is clearly the least supported by
the basic economic analysis of the situation. Its great
advantage is that it is more accessible than the market
value of capital and changes less often. A version of
it was used by Prussmann and Murphy in their survey
14C. A. Westwick, “Towards a New Measure and Use of
Gearing”, Accounting and Business Research, I, Winter
1970,page 18.
15s. Archer and C. A. D’Ambrosio, Business Finance:
Theory and Management, Collier-Macmillan, 1966, page
512.
16R. Marris, The Economic Theory of Managerial
Capitalism, Macmillan, 1964.
17K.Midgeley and R. G. Burns, Business Finance and
the Capital Market, Macmillan, 1969,pages 59-60.
18J. C. Van Horne, op. cit., page 679.
19Op. cit., page 20.
95
of ‘Gearing in British Quoted Companies’;20 they
note that the definitions used were mostly inherent in
the SCAN Investment Analysis System they used for
the retrieval of the data they analysed. Buckley also
used this definition and noted that he did not agree
with its exclusion of short-term debt but that “the
definition . . . was chosen to conform with available
statistics for industrial companies in general”,Zl
particularly those of Prussmann and Murphy.
MM used Alternative (ii), capital amounts at
market values, in their original proof without explicit-
ly stating this. In their 1969 proof they slide into
Alternative (iii) towards the end though they avoid
leverage terminology there. Although there is some
evidence of high correlation between these two
measures in practice, they are not equivalent and may
produce different rankings of gearing. We cannot
begin to determine which of the two is more suitable,
in the MM context or in more general use, until we
have considered why measures of gearing are of any
use or significance. Choice of the arithmetic form of
the chosen measure tends to follow naturally from the
use envisaged. Some of the confusion about gearing
measures arises from the many transformations of
formulae that have been used to produce completely
different numbers for what are essentially the same
measure. Any. capital
- measure can be expressed as
D D S
- or -or -or the inverse of any of these.
S S+D S+D
x
Income measures can be written as -(times interest
rD
X rD
covered) or -or -or the inverse of any of
X-rD X-rD
these. It will be seen that the use of a measure needs
to be established first; then its form as well as its basis
are determined so that it can be used as a multiplier
or transformation factor relative to the characteristics
being compared.
Pearson Hunt22 identifies two “approaches to the
phenomenon” which call for separate, though closely
related, measures. He makes the wise suggestion that
we give the two measures different names. He follows
K0hler23 in using the term “trading on the equity”
for the factor by which the rate of return on total
20D. Prussmann and G. Murphy, “Gearing in British
Quoted Companies”, Business Ratios, Vol2, No. 3, Winter
1968.
21A. Buckley, “A Profile of Industrial Acquisitions in
Accounting and Business Research 8, Autumn 1972,
1971”~
page 250.
ZzPearson Hunt, “A proposal for Precise Definitions of
‘Tradingon the Equity’ and ‘Leverage’,” Journal of Finance
September, 1961,page 377.
23E. L. Kohler, “A Dictionary for Accountants”, Prentice
Hall, 1952, pages 427 and 254.
 96
capital is multiplied to give the rate of return on equity
capital. In symbols “trading on the equity”
X-rD .V24
(TE) = - - This could be called a mixed
s x
capital and income measure, and Hunt sees it as
taking the viewpoint of management seeking “to
determine the desired proportion of debt to equity in
the corporation”.
He also follows Kohler’s definition of “leverage”
as the factor by which a percentage change from
present levels of income before payments for prior
charges has to be multiplied to give the consequent
percentage change in equity income. In MM termin-
X-rD
ology leverage (L) = - Rix gives this income
x. 25.
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measure the appropriate title of “revenue gearing
multiplier”.26 Hunt sees this measure as taking the
investment analyst’s viewpoint, as he considers the
consequences to equity of varying levels of income
before charges. This may well be the viewpoint of the
switching investor in MM’s proof.
I am inclined to retain my previous view27 that a
pure capital measure of gearing is only of significance
in the face of a real prospect of liquidation. Within a
firm this will be a relatively rare situation, but the
condition is not as restrictive as it sounds. A creditor -
long-term or current trading - will only face a risk
situation if the firm indebted to him is unable to meet
its obligations and so faces insolvency. In this situa-
tion however market and book values of loan and
equity capital are equally inappropriate; the relevant
figures are the liquidation values of the assets and of
any claims ranking ahead of the creditor whose
interests are being considered.
But market values of capital are relevant to those
many equity investors who seek their gain wholly or
partly from rises in capital values rather than from
their share of equity income. The extremes of this
are holdings of the capital shares of split trusts and
holdings of share warrants. The latter may be regarded
as a form of investor gearing, since the investor in
warrants buys the rights to the gain in the market
value of more initial investment than his original
24X.
- TE=X-rD- .: TE=X-rD - - . V . Where there are no
V S s x
prior charges. S =V and D =0, hence TE= I .
- L =d(X-rd) .: L =d(X-rD)
25dX. - - . X . As rD is
X X-rD X-rD dX
fixed, thenL= dX .X = X .
X-rD dX X-rD
26M. S. Rix, Investment Arithmetic, 3rd Edition, Pitman,
1971’ Page 234.
27Peter Bird, The Interpretation of Published Accounts,
H.M.S.O., 1971, page 14.
A C C O U N T I N G A N D B U S I N E S S RESEARCH
capital. If warrants to purchase for E1.00 shares now
quoted at EI-OOcost 25p, an investor with A;I,OOO
capital who can only purchase 1,000 shares can, in-
stead, purchase 4,000 warrants. Since no income is re-
ceived by the warrant-holder unless and until he exer-
cises his warrant, no income-based measure of gearing
is meaningful or possible. Kennedy28 defines the gear-
ing ratio of warrants as “the ratio of the initial price of
the ordinary to the cost of the warrant”, corres-
ponding to his measure of gearing by borrowing
V
which is - in MM terminology. Thus in the example
S
above the gearing ratio is -
1’00
0.25
= 4, since the investor
can buy four times as many warrants as shares.
But there are also investors in the market who are
interested in the equity income stream and the
financial risks attaching to it. These income oriented
investors are likely to view two investments as having
rcequivalent leverage” if the values of some such
X
measure of their holding as .- were equal. It is
X-rD
relevant to ask whether the arbitrage process would
operate in this circumstance, despite the fact that this
entails ascribing a numerical value to X whereas MM
treat it as a random variable.
In the original proof given by MM (Archer and
D’Ambrosio p.133), the amount to be borrowed is
D
determined so as to equate - or rD before and after
S
the switch, and then the income after the switch is
shown to differ from that before the switch except
where V, = V,. The amount to be borrowed is now
recalculated on the assumption that the aim is to
X
equate the investor’s - before and after the
X-rD
switch. The amount to be borrowed on personal
account (D,) must now be such that
&+DPX
Sl X
X-rDp X-rD
Sl
(subscript, refers to the ungeared firm and subscript,
to the geared firm).
Thus: Dp=aD, - ” - aD2- Vz-D,
S1-Dz V1-Dz
When V,=v,, but not otherwise, vz-Dz - I and
V1-%
ZCharles Kennedy, “Two Types of Gearing”, un-
published discussion paper, University of Kent at
Canterbury, 1972.
 SPRING 1973 97
D,= aD, as used by MM29. before switching:
The income from investing ( aS2+Dp) in the un- Y,= ax-r aD2
geared company and paying interest on Dp out of the if and only if the expressionsin brackets take the value
dividends is
I. This is true of vz-Dz only when V,=V,, and in
V,-Dz
that circumstance S2+Dz will also be unity. If
~

S,

-raD2 (;s2) Vz>Vl, then -

2-D > I,
Vr D 2
and the expression in

Vz-D,+
square brackets, which can be written as -

[:-+-: (ve)]
V,

=aX ( ) 3 ”. is also greater than unity.

Downloaded by [Australian National University] at 17:21 15 March 2015

v, V1-Dz I
\
Therefore when V,>V, then Y,>Y, and switching
from firm2 to investment of “equivalent leverage” in
firm I is beneficial. MM Proposition I can still be
‘proved‘ when an income definition of gearing is
adopted, though the proof does not give the intellec-
This will equal the income from the geared company tual provided by the clarity and simplicity
- of the original MM version.
29 aS2X+DpX -
-
X What isthe moral of all this? Apart from a warning
aS2X i-DpX-rDpS 1 X-rDz to beware of secondary sources, it is that we need to
:. X( aSzXfDpXI-rDzX (aSzfDp) consider whether we are content to have everyone act
= X (aS2XSDpX-rDpSI) like Humpty Dumpty who said “When I use a word
:. aSzX+DpX-rDz( as2 -tDp) it means just what I choose it to mean - neither more
= aS2X+DpX-rDpS1 nor 1essyy.3~ The question is, as Alice pointed out,
:. Dt(aSz-i-Dp) = DpSl whether you can make words mean so many different
:. D ZaS2 = DpSl-DpDl things.
:. DzaSZ = Dp
SL - D ~ 3oLewis Carroll, Through the Looking Glass, Chapter VI.