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The question asked to discuss the factors which will determine the long term policy. The way examiner wrote the answer is a bit confusing for me.
First it talks about Optimal level of gearing, so I believe this is one of the factors they need to to keep in mind when determining their policy.
– Can you explain what they mean by a balance of risk and advantages is needed to maintain and optimal gearing level?
– another factor which they should keep in mind when determining their long term finance policy is what source of finance to use but then they move forward and explain the the pecking order. I am confused with this answer as how is pecking order a factor when determining the long term policy.
Theoretically there is an optimum level of gearing at which the cost of capital is at a minimum and if the current level of gearing is the optimum then they should maintain that level.
However, that assumes that they will keep having sufficient cash to pay the interest on debt and sufficient to pay shareholders the dividends they require. That is what the answer is meaning with regard to the balance of risks.
As far as pecking order is concerned, in the real world they will not even know what the optimal level of gearing is, and in deciding on how to raise new finance the might decide that the prefer to use retained earning first because (as the answer goes on to explain) it avoids them having to issue new shares.
So the question asks discuss the factors which determine the long-term finance policy
Can I mention the factors based on which a company decides their long-term finance policy is:
the level of gearing they want to maintain
sources of finance they want to use
period for which loan should be taken?
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