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  1. Hello sir,
    I’m so confused about this MCQ
    My answers are A & D
    The actual answers are B & D
    Which TWO of the following are most likely to result in a company’s financial gearing being high?
    A Low taxable profits
    B High tax rates
    C Inexpensive share issue costs
    D Intangible assets being a low proportion of total asset

    The explanation for B is that high  tax  rates  mean  that  there  is  a  larger  tax  shield  on  interest  payments  on  debt  finance, making  debt  more  attractive. I can’t understand what’s actually they are saying!
    For me A is much more accurate, as gearing rises interest increases and results in low taxable profits
    Please Explain!

    • In future you must ask this kind of question in the Ask the Tutor Forum and not as a comment on a lecture.

      Debt interest is allowable for tax and so make debt borrowing cheaper than equity borrowing (because dividends are not allowable for tax).
      This is all explained in later lectures on the cost of finance.

      I have no idea why you have come to this page anyway. Paper F9 is now called Paper FM and you should be using the lectures linked from the main Paper FM page!!

  2. Hi again 🙂

    In the financial gearing ratio formula the preference share capital have been included in the numerator which makes them a debt by default . My question is that are the preference shares considered a debt to the company ?? Guide please …

  3. Hi John

    In your lecture you say that the examiner will be clear whether he wants you to use book or market values.

    Will the examiner say ” calculate total gearing using book values (or market values)? or will it just depend what information is he given you. For example if he gives you a SOFP and the market values, are you to assume that you use the market values because he has given them?

    Hope that question makes sense.

    Many thanks

    • I don’t know which notes you are using, but it is not page 75! The example is on page 71 and share capital is 10,000 and reserves are 130,000. So the total book value (when using book values for gearing) is 140,000.

  5. on the video the lecturer has been concluded that Book Value is better than Market Value in calculating gearing which the Market Value will overestimate the Equity part on Gearing Equation but on BPP Kit on one of the questions said that why Market Value WACC is better than Book Value WACC? and the answer on part of the answer of this question is the book value made understmate of equity and therefore understmate WACC So, it has been concluded that Book Value is better >>>> What do you think of those two opposite ideas ?

    • I have not concluded that at all in the lecture!!!

      We always calculate the WACC using market values (unless specifically told to do otherwise which is rare).

      Nowhere in any of the lectures do I suggest that using book values is better than using market values.

  6. Hi John,

    Is there a lecture where you discuss financial and operating gearing in detail? The lecture before this is convertible debt..or am I missing something?

  7. Hi John,
    I’m struggling to get the concept that why Market values are preferred over book values in the calculation. Suppose, a company issues a share for $1 & even if the MV of the share is $10, its just the price at which share is being traded on stock market, the value that company got for the issue of share is $1.
    Same goes with the bond, if company issued a bond at $100 & has to redeem it at $100, if the bond is being traded at 95, it does not reduce the company’s gearing?
    I cannot really get the point of calculating gearing using market values.

    • Four things. Firstly, the total borrowed from shareholders is not simply the share capital – it is the share capital plus reserves, and the most obvious reason for the market value of the shares being higher than the nominal value is because of the reserves that have been earned.
      Secondly, if new bonds were to be issued to replace the existing bonds, then they would have to be issued at the current market value.
      Thirdly, if (hypothetically) all lenders (shareholders and bond holders) were to be repaid today, they would want to be repaid at current market values.
      Finally, the total value of a business is never going to be the book value in the Statement of financial position – it is the total market value (and that is financed partly by equity and partly by debt).

      • The reserves belong to shareholders & the reason for the market value of shares being higher are the reserves (earnings) of the company, but then practically, why it is that the total market value of a company’s shares is not equal to, in fact it could be much different from, the share capital + all the reserves of the company?
        Secondly, what are the reasons for the market value of a bond being different from its original value & is it that the market value is higher than par value due to future interest & why the market value could be lower than par (particularly if the bond is to be redeemed at par) ?

      • This is all explained in the lectures on the valuation of securities.

        With regard to shares, the market value depends on the shareholders expectations of future dividends and their required rate of return.
        With regard to bonds, the future receipts are fixed but again their required return will change (depending very much on whatever general interest rates are).

        Again, do watch the free lectures on the valuation of securities where all this is explained.

  11. Hi Sir
    From the lecture, there are two ways of looking at gearing, the market value and balance sheet value. Which of this shows the real gearing of the company

  12. Hi John,

    Excellent lecture as per usual! I just have one question on Example 2 part (b): when calculating the Equity at market value, how come you don’t include Reserves? I’m a bit rusty on F3 🙂

      • hello,john thank you very much for your lecture. but i m little bit confused about calculating gearing in a market value…why u did not add reserve in equity …please let me clear it.. thank you

      • One of the main reasons why the market value of equity is more than the original capital is because the business has been making profits and is therefore ‘bigger’.
        So the market value effectively already includes the reserves.

    • No – it is not correct.

      If share capital is $10,000 and they are $0.10 shares, then there are 10000/0.10 = 100,000 shares.
      If the market value is $2.20 per share, then the total market value is 100,000 x $2.20 = $220,000

  15. Master John, as far as I’m concerned, the figure of equity thas is used for the calculation of the financial leverage includes retained earnings as well. In example 2 of course, the BS couldn’t balance if there were retained earnings as well, so I guess Lavetal doesn’t have any.

    However, if there were retained earnings as well, should we include these in the “equity” figure?

      • There are two ways of looking at gearing depending on what information is available.

        The best way would be to use the market values of debt and of equity – if you have these then reserves are not relevant (because the market value is already taking these into account).

        If you do not have market values then it means we have to use balance sheet values. In this case you take the total shareholders funds (share capital plus all reserves).

  17. Same question i had , but if you listen to this with full focus you will realize that john has indeed made operational gearing concept clear but has stated that he will not be doing numbers on it as perhaps there is no fixed way of doing so.
    Operational gearing , btw, is a measure of variable costs to fixed costs.Hope this helps a little.

  18. Where is the discussion bit for financial gearing and operating gearing.I recon it’s supposed to be at the beginning of this lecture, which might have been cut off. If that is not available, pls make that available with the old lectures to cover it a bit.

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