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Sir, under optimal gearing position, my study text sates that -” paying large dividend reduces the value of equity in the firm, so can help move towards its optimal gearing position”
Sir i understand that retained earnings will fall, so equity may fall, and because proportion of gearing will increase relative to equity, the gearing ratio(debt / equity ) will rise. how is this optimal?
2nd doubt. if i use the market value of equity to measure gearing, the investors may drive the company’s share upwards in exuberance, so in that case gearing will infact fall.
Under the traditional theory of gearing there will be an optimal level of gearing, and if they have not yet reached that level then reducing the value of the equity will help move towards optimal gearing. The statement you quote does not say that it will move toward optimal gearing, it says that it can (i.e. might) help.
According to M&M, a company should be as highly geared as practically possible in which case they will always want to increase the gearing.
It is always more sensible to measure gearing using MV’s (values in the SOFP are virtually meaningless). It is always the case that if (for whatever reason) the MV of equity increases then the level of gearing will fall. That does not conflict with the first statement.
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