Optimal Capital Structure and Gearing Ratio Analysis

Running head: INTRODUCTION TO FINANCE
Introduction to finance
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1INTRODUCTION TO FINANCE
Table of Contents
Answer (i) – Optimal capital structure..............................................................................................................2
Answer (ii) – Gearing ratio................................................................................................................................2
Letter of recommendation...............................................................................................................................3
Reference.........................................................................................................................................................5

2INTRODUCTION TO FINANCE
Answer (i) – Optimal capital structure
Gearing ratio Rio Tinto Wesfarmers
Ratio Formula 2017 2016 2017 2016
Debt to equity ratio Total debt/total equity 0.87 0.95 0.68 0.78
Debt ratio Total debt/total assets 0.47 0.49 0.40 0.44
Optimal capital structure is the financial metric used for determining the appropriate mix of debt
and equity for the company at which the company’s cost of capital is lowest. The optimal capital structure
helps the company to become less dependent on the creditors and lenders and is able to manage the
required fund through the equity (Akeem et al., 2014). The company’s capital structure is highly dependent
on the availability of fund and requirement of the company. Company’s capital structure has an impact on
its weighted average cost of capital which in turn affects the return of the shareholders ( Peirson et al.,
2014). However, the company requires less capital to satisfy the demand of shareholders as compared to
the equity holders. The reason is that the interest payment and debt payment payable to the debt holders
are deductible under tax whereas the returns paid to equity holders are not deductible. Debt equity ratio of
1 or lower is considered as healthy and optimum for any firm as it states that the debt of the firm is equal
to the equity or lower than equity (Renneboog & Szilagyi, 2015).
From the above calculation table of debt to equity ratio for Rio Tinto and Wesfarmers over the
years from 2016 to 2017 it has been identified that both the firms have optimal capital structure. For Rio
Tinto the debt to equity ratio for the year 2016 was 0.95 and for the year 2017 it was 0.87 whereas for
Wesfarmers the debt to equity ratio for the year 2016 was 0.68 and for the year 2017 it was 0.78.
Therefore, it can be stated that both the companies are maintaining optimum capital structure.
Answer (ii) – Gearing ratio
Gearing ratio represents the percentage of company’s asset is obtained through borrowing and
percentage of asset obtained through equity. It reveals the financial risk exposure of the company and its
leverage level (Halili, Saleh & Zeitun, 2015). Excess level of the debt put additional burden of interest to
the company that can lead it to the financial difficulties. High gearing ratio that is more than 40% denotes
that the higher proportion of the company’s assets obtained through borrowing. It also denotes that the
company is highly leveraged where the company utilizes higher portion of debt for continuing its operation
(Bendell & Doyle, 2017). Therefore, under the business and economic downturn the company may face