Syllabus B. Advanced Investment Appraisal B3. Impact of financing on investment decisions and APV

Gearing drift 13 / 18

Dealing with 'gearing drift'

Profitable companies will tend to find that their gearing level gradually reduces over time as accumulated profits help to increase the value of equity. This is known as "gearing drift".

Gearing drift can cause a firm to move away from its optimal gearing position.

The firm might have to occasionally increase gearing (by issuing debt, or paying a large dividend or buying back shares) to return to its optimal gearing position.

Signalling to investors

In a perfect capital market, investors fully understand the reasons why a firm chooses a particular source of finance.

However, in the real world it is important that the firm considers the signalling effect of raising new finance. 

Generally, it is thought that raising new finance gives a positive signal to the market: the firm is showing that it is confident that it has identified attractive new projects and that it will be able to afford to service the new finance in the future.

Investors and analysts may well assess the impact of the new finance on a firm's statement of profit or loss and balance sheet (statement of financial position) in order to help them assess the likely success of the firm after the new finance has been raised.