Optimal capital structure

Financial gearing:

Financial gearing is a percentage of debt capital in the company’s capital structure. If company has high gearing that means a company borrow a lot debt capital. (Main text book).

Optimal capital structure:

The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital.

b) Explain why the cost of equity capital (ordinary shares) is normally higher than the cost of debt capital. (slides)

Ordinary shares carry higher risk than debt capital, hence will require higher return to persuade investors to invest. Higher issuing cost of equity relative to the cost of issuing debt capital. Dividend on ordinary shares are not allowable against corporate tax while interest payments are.

c) What is meant by the term ‘dividend pay-out ratio’? How is this ratio related to ‘retention ratio’?

Dividend pay-out ratio:

The percentage of earnings paid to shareholders in dividends.

Retention ratio:

The proportion of net income that is not paid out as dividends.

d) Distinguish between the ‘Signalling Effect and the Clientele-Effect’ of dividend of dividend policy.

Signaling Effect:

A theory that suggests company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. It comes from game theory. A manager who has good investment opportunities is more likely to "signal" than one who doesn't because it is in his or her best interest to do so.

Clientele-Effect:

The clientele effect is the concept that shareholders are attracted to firms that follow dividend policies are the same as their objectives. The clientele effect encourages stability in dividend policy.

e) From the Formula Sheet provided, copy the formula for the calculation of the beta of a risky individual asset, and explain the meaning of