Gearing Theory Critical Review

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3.0 Critical review of the Gearing Theory 3.1 Traditional Gearing theory Skare (2002) stated in his research that the traditional gearing theory excludes the short-term financing from the cost of capital calculation which the firm’s capital structure can be viewed as a required rate of return that must be earned on an investment leaving the firm’s value unaffected which supported the traditional gearing theory. Afrasiabishani (2012) also supported the traditional theory by stating that traditional approach is based on the belief that optimal capital structure always exists, this approach is a combination of (NI) and (NOI) in the finding of his research. 3.2 Irrelevance theory of Modigliani and Miller According to Sten and Chew (2003),…show more content…
In the case of default, the assets of the company will be seized; however, the company will be safe from bankruptcy. Moreover, firms having a large amount of tangible assets are less likely to default and will acquire more debt. This supported the assumption of the trade-off theory and concluded that there is a positive correlation between leverage, and profitability of a firm, whereas tangibility of assets and the size of the firm found positively correlated with firm’s leverage (Butt, 2013). Antonious, Guney, and Paudyal (2002) concluded that firm size is positively correlated with leverage ratio. The tangibility of assets was found positive in those countries where lending from banks was significant. Um (2001) argued that high profitability results in a higher debt capacity of the firm and hence, a firm can have more tax shield. Therefore, according to the tradeoff theory there exist a positive relationship between profitability of a firm and financial leverage. Zeitun, R. and Tian, (2007) supported the trade-off theory as according to their study, the literature has misinterpreted the evidence (which implies that profits are negatively related to leverage) as a result of the wide-spread use of familiar but empirically misleading leverage ratios. The study proved that a highly profitable firms typically issue debt and…show more content…
Then, several key gearing theories which are the traditional gearing theory, irrelevance theory of Modigliani and Miller, the trade-off theory and the pecking order theory were critically evaluated in this report. In conclusion, based on the critical evaluation, the appropriate use of key gearing theory in today’s world is the trade-off theory and pecking order theory. This is because, the theories are widely being used in the current studies and industries. As for trade-off theory, it helps a firm to determine the most optimal debt-to-equity ratio which focuses on bankruptcy cost and debt, while pecking order theory helps the finance managers to maintain the control of the firm, and minimizing the cost of equity and agency problems which is a significant issue to be addressed in by financial practitioners in today corporate
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