Shareholder's wealth & gearing

[luckystrike]

The consultant that I spoke to recently explained that some academic theorists have the idea that, if your objective is to maximise shareholder wealth, the debt to equity ratio does not matter.  However, they did comment that this held in a world of no taxes.  Even more strangely, the consultant said that in a world with tax, it is best to gear-up the company to as high a level as possible.

I don't know much about academic theory, but I do know that there are limits to the level of debt which is desirable.

I'm now more confused than ever!  Can anyone help?

[ewand]

Briefly, and I can go into more detail if necessary.....it seems like your consultant is familiar work by Modigliani and Miller, who stated that "dividend policy doesn't matter in perfect capital markets......" suggesting that capital stucture (debt vs equity) is irrelevant as long as a firms investment decisions are taken as given. However, there are imperfections, for example when all investment decisions are not funded out of firm equity.....which happens quite regularly. Therefore it is not advisable to run a company high up into debt. High debt means high gearing, which is good for some companies (provided their credit history and rating is good) has to be watched with caution.....anything over 75% is high, and should be looking to drop over a period. As for tax, when the WACC (weighted average cost of capital)is used for investment decisions (which is extremely regularly), tax is almost certainly an issue. Hope this is helpful......