4 (a) A company may choose to finance its activities mainly by equity capital, with low bo

Question

4 (a) A company may choose to finance its activities mainly by equity capital, with low borrowings (low gearing) or by

relying on high borrowings with relatively low equity capital (high gearing).

Required:

Explain why a highly geared company is generally more risky from an investor’s point of view than a company

with low gearing. (3 marks)

Answer 1

正确答案：
(a) A highly-geared company has an obligation to pay interest on its loans regardless of its profit level. It will show high profits if
its overall rate of return on capital is greater than the rate of interest being paid on its borrowings, but a low profit or a loss if
there is a down-turn in its profit such that the rate of interest to be paid exceeds the return on its assets.