2. MV of a company
Future cashflows
Wacc
If we can reduce this by changing
gearing, then shareholder wealth
increases
3. Impact of gearing?
Should decrease WACC because debt is
cheaper
Should increase WACC because more debt
means more risk to shareholders and so
increase cost of equity
5. M&M theory
(no tax)
Debt is cheaper but cost of equity rises so
WACC is constant. Gearing irrelevant.
6. M&M theory
(with tax)
Debt is cheaper and greater than the
related cost of equity rises so WACC falls.
Get as much debt as possible.
7. Betas
In an ungeared company it simply represents
the business risk. It is called the Asset Beta.
In a geared company it represents both
business risk and the further risk that debt
brings, financial risk. This is called Equity
Beta
8. Choosing a beta
Get an appropriate asset beta (same as a
company in that business)
Adjust it to our gearing levels. Make it an
equity beta
9. If the only appropriate
beta is an equity one
Degear the equity beta to an asset beta
Readjust the asset beta to our own gearing,
to get our equity beta
11. A is considering moving into B’s business. What is
a suitable cost of capital?
A ltd: Equity:debt ratio = 5:2. The debt is
risk free and yields 11%. Beta value 1.1
Average return on stock market = 16%. Tax is
30%
B ltd: Equity:debt ratio = 2:1. Beta value 1.59