W and Y are very similar entities with the same level of profit before interest and tax.  However, W has gearing of 95% and Y has gearing of 30%…

Financial gearing, or leverage, measures the extent to which a company is funded by debt. Company W, with 95% gearing, is heavily reliant on debt, while Company Y (30% gearing) is less so. High gearing magnifies financial risk because the company has a significant fixed obligation to pay interest, regardless of its profit level. If Profit Before Interest and Tax (PBIT) declines, a highly geared company like W is more likely to default on its interest payments, increasing the risk of insolvency. Therefore, investing in W carries a higher level of risk for shareholders compared to investing in the less-geared Company Y.

B. A greater proportion of profit will be available out of which to declare a dividend in W.

W has higher debt, leading to higher interest payments. This reduces the profit available to shareholders for dividends compared to Y, given the same PBIT.

C. Investors in Y will expect a higher return than investors in W.

Investors demand higher returns for taking on higher risk. Since W is the riskier company due to its high gearing, its investors will expect a higher return.

D. Y has a greater commitment to meet interest payments than W.

W has a higher level of debt (95% gearing vs. 30%), meaning it has a larger fixed commitment to make interest payments compared to Y.

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1. Myers

S. C. (2001). Capital Structure. Journal of Economic Perspectives

15(2)

81-102. (DOI: https://doi.org/10.1257/jep.15.2.81). This paper discusses how leverage increases the risk of the firm's equity. Section "Leverage and the Cost of Capital" explains that as a firm borrows more

the risk borne by stockholders increases

and so does the expected rate of return on their investment.

2. Brealey

R. A.

Myers

S. C.

& Allen

F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. In Chapter 17

"Payout Policy

" and Chapter 18

"Does Debt Policy Matter?"

the authors explain that higher leverage increases the volatility of earnings per share and the risk of financial distress

thus increasing the risk for equity investors.

3. Massachusetts Institute of Technology (MIT) OpenCourseWare. (2008). 15.401 Finance Theory I

Fall 2008. Lecture Notes

Lecture 15: Capital Structure I: Modigliani-Miller. Retrieved from https://ocw.mit.edu/courses/15-401-finance-theory-i-fall-2008/resources/mit15401f08lec15/. Slide 11 demonstrates how leverage increases the risk (beta) and expected return of equity

confirming that higher gearing leads to higher risk and higher expected returns.