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CHAPTER SIX

GEARING AND THE COST OF CAPITAL

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 Learning Outcomes
On successful completion of this Chapter, students should
normally be able to:
• Identify the principal interest rates in the UK financial markets
• Explain the term structure of interest rates
• Define and calculate weighted average cost of capital for
companies with simple capital structures
• Explain the traditional view of the relationship between cost of
capital and capital structure
• Explain the view expounded by Modigliani and Miller of the
relationship between cost of capital and capital structure
• Perform arbitrage calculations that support the view of
Modigliani and Miller
• Identify and discuss critically the assumptions underpinning
the pre-tax version of the Modigliani and Miller model
• Discuss the possible impact of incorporating taxation in the
Modigliani and Miller model

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The Weighted Average Cost of Capital
Example:
The following information relates to the long
term funding of Thompson plc:

Market
Value
Component of Capital Cost £000
Ordinary Shares 15% 980
Preference Shares 12% 550
Debentures 8%   350
1,880
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The Weighted Average Cost of Capital
Example:
The following information relates to the long
term funding of Thompson plc:

Market
Value Cost x MV
Component of Capital Cost £000 £000
Ordinary Shares 15% 980 147
Preference Shares 12% 550 66
Debentures 8%   350  28
1,880 241
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The weighted average cost of capital is
the sum of the products
(£241,000 in this case)
divided by the sum of the weightings
(£1,880,000 in this case),
i.e. £241,000/£1,880,000
= 0.12819..., say 13%.

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 The Traditional View of the
WACC‑Gearing Relationship
Historically, fixed interest investors have not demanded
as high a return as equity investors.
This is because they experience a lower level of risk.
Hence, it is argued, the introduction of debt into a
previously all-equity company will lower the WACC at
low levels of gearing.
As gearing increases, equity holders will require higher
returns in order to compensate them for the increase in
risk.
At very high levels of gearing the fixed-interest investors
will themselves demand a higher return for higher risk.

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 The Traditional View of the
WACC‑Gearing Relationship
Thus, WACC will decrease at low levels of
gearing and increase at higher levels.
The WACC profile against gearing will be saucer-
shaped at low and medium levels of gearing,
indicating that for a particular company there is
an optimum mix of debt and equity.
This is shown in Exhibit 1 below, where f(x) is
the WACC, expressed as a percentage, and x is
the level of gearing, expressed as the ratio of
debt to total funding:

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 40

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f( x ) 20

10

0
0 0.2 0.4 0.6 0.8 1
x

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If the traditional view is an accurate
representation of how WACC varies with
changes in gearing,
then it should be possible to create wealth
by optimising the firm’s capital structure.
The next section shows how this would
happen.

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Creating Wealth in a Firm by Changing
its Capital Structure

The following two assumptions are made:

• Investors prefer more wealth to less
• The wealth associated with a project may
be measured by calculating its net present
value, as in the example below:

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Leverage Ltd. is an all-equity financed company
that has a cost of capital of 12%. The net present
value of Project X is calculated as follows:
Cash 12% Present
Flow Discount Value
Year (£000) Factor (£000)
0 (1,000) 1 (1,000)
1 400 0.893 357
2 500 0.797 399
3 600 0.712 427
183 = NPV

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Clearly, the amount of wealth (the NPV) is critically
dependent on the discount factors and hence on
the choice of discount rate.
Now, suppose that the traditional view is reliable, and
that the following additional information is available.
Leverage Ltd. is a company in which the cost of equity
capital is 12% at low levels of gearing.
The cost of debentures at low levels of gearing is 7%.
The company moves from being all equity financed to
being funded partly by debentures, and the ratio of the
market values of debt to equity is 2:3.
Despite this change in the company’s gearing, the costs
of both equity and debt are unaltered.
The weighted average cost of capital (WACC) of
Leverage Ltd. is calculated as follows:

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 2 x 7% + 3 x 12%
WACC=  10%
5

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Year Cash Flow 10% Discount Present Value (£000)
(£000) Factor
0 (1,000) 1 (1,000)
1 400  0.909 364 
2 500  0.826 413 
3 600  0.751 451 
228 
NPV at 10% DF

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Year Cash Flow 10% Discount Present Value (£000)
(£000) Factor
0 (1,000) 1 (1,000)
1 400  0.909 364 
2 500  0.826 413 
3 600  0.751 451 
228 
NPV at 10% DF
Year Cash Flow 12% Discount Present Value (£000)
(£000) Factor
0 (1,000) 1 (1,000)
1 400  0.893 357 
2 500  0.797 399 
3 600  0.712 427 
183 
NPV at 12% DF
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It appears that the introduction of debt into the
company has resulted in an increase in wealth
from £183,000 to £228,000.
This conclusion relies on the assumption that the
cost of equity will remain unchanged despite the
introduction of debt.
It is as if the holders of equity have not noticed
that their risk position has worsened.
The question arises as to whether this is likely
— will the holders of equity really fall asleep and
not notice that debt has been issued and their
risk increased?

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If the cost of equity remains more or less
unchanged
(because enough of the ordinary shareholders
fail to notice the introduction of debt)
then there is an opportunity to make abnormally
high returns for anyone who does notice.
To put it another way,
the ordinary shareholder who remains alert
when the cost of equity remains unchanged
despite the introduction of debt has access to
a money making machine...

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 A Money Making Machine
(or Profiting through Arbitraging)

Ordinary Limited is a company that is

identical to Leverage Ltd. except for
funding.
Both make an operating profit of £96,000
p.a.
and both companies have a policy of
paying out all residual profit as dividend.
Further details are as follows:

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 Market Value
Leverage Ltd. £000
400,000 ordinary shares of £1 each 625
£300,000 7% debentures 300
925

Market Value
Ordinary Limited £000
400,000 ordinary shares of 50p each 800

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The pre-interest profit of £96,000 is apportioned
as follows:

Leverage Ordinary
Ltd. Limited
£000 £000

Profit before Interest 96 96

Interest
(7% x £300,000) 21 nil
Dividend 75 96

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Note that the return on equity in Leverage
Ltd. is 100% x 75,000/625,000 = 12%,
and that the cost of equity for Ordinary
Limited is also 12%
(100% x 96,000/800,000 = 12%).
So, the market values of the two
companies are in line with the traditional
view that at low levels of gearing equity
investors do not require increased return
for low levels of financial risk.

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Note that the total market values of the two
firms are different,
even though the companies are identical in all
respects except for their sources of funding.
This is a result of the return on equity in both
companies being the same, although one
company also has debt.
That the total market values of the two firms are
different,
even though the companies are operationally
identical,
is arguably anomalous...

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 If an investor wanted to gain an annual income of
£96,000 they could either
1. buy all the shares in Ordinary Limited and receive
dividends totalling £96,000 each year, or
2. buy all the shares and all the debentures in Leverage
Ltd. and receive interest on their debentures of £21,000
and dividends of £75,000.
Either alternative would yield an annual income of
£96,000, as required.
However, to buy all the shares in Ordinary Limited
would only cost £800,000
compared with the cost of acquiring the shares and
debentures in Leverage Ltd. of £925,000.
(Recall that the companies are subject to the same level
of business risk.)

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Roxy holds 4,000 ordinary shares in Leverage
Ltd. with a market value of £6,250.
The level of risk associated with this investment
is exactly the level she wants, or to put it
another way, the shareholding reflects her
attitude towards risk.
A strategy to increase her wealth without
altering her risk position is as follows:

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1. Sell the shares for 1% x £625,000 = £6,250
2. Substitute personal borrowing for the corporate
debt by borrowing 1% x £300,000 = £3,000 at
7% p.a.
3. Roxy has funds of £(6,250 + 3,000) = £9,250.
She uses this to acquire 1% of the equity in
Ordinary Limited, buying 4,000 shares at £2
each for £8,000. This realises a capital gain of
£(9,250 – 8,000) = £1,250.

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As an investor in Ordinary Limited, Roxy’s annual
return is now calculated as follows:

£
Gross annual return from Ordinary
Limited of: £96,000/0.4m = 24p
per share: 24p x 4,000 shares = 960 in total
Less: interest on borrowings of   
7% x £3,000 = 210
Receive a net return of £750

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 Exercise:

Calculate the WACC of:

1. Leverage Ltd.

2. Ordinary Limited
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The view of Franco Modigliani and Merton H
Miller is that the state of affairs outlined above
would result in investors selling shares in
Leverage Ltd. and buying shares in Ordinary
Limited.
This would result in the price of shares in
Leverage Ltd. falling
and the price of shares in Ordinary Limited
increasing
until an equilibrium position was reached
at which point there would be no benefit in
adopting the arbitrage strategy.
That view is discussed further in the next
section.

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 The Modigliani and Miller View
The essence of this view is that firms of identical
size
experiencing identical operating risks
are identical in all material economic aspects
and will therefore have the same value
— and hence the same WACC —
irrespective of their gearing.
Hence, the WACC profile is a straight line
parallel to the x-axis.
Thus, the MM view is that the capital structure
of a firm is irrelevant to its value.

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The value of a firm stems from
expectations about the future cash flows
that the firm will generate.
Investors are effectively buying future
cash inflows,
if a particular set of cash flows is available
from a choice of two investments (of
identical risk) then the cash flows should
cost the same.
If they have different prices,
rational investors will switch from the
more expensive to the cheaper company
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There are two arguments that are
fundamental to the Modigliani and Miller
view:-

• The issue of debt increases the risk for

holders of equity.
These holders therefore demand an
increase in return which will exactly offset
the effect on WACC of the use of the
cheaper debt financing
• At high levels of gearing,
risk-seeking investors will buy equity for
the first time.
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 The Equilibrium Position

For ease of calculating the equilibrium

share price for the geared company:
assume that the market value of the debt
in the geared company is correctly priced,
deduce the value of the equity,
divide the market value of the equity by
the number of ordinary shares in issue.

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Abandoning the Heroic Assumption
(by Incorporating Taxation)
Interest on corporate debt is tax allowable
(deductible) in the UK and USA,
whereas dividend payments
(being an appropriation of profit, rather
than an expense)
are not.
There is therefore an advantage
associated with debt financing.

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Consider an example in a world in which corporate
taxes are charged at 25%:

G Ltd. E Ltd.
£ £
Profit before interest and tax 1,000 1,000
Interest 160 nil
Profit before tax 840 1,000
Taxation 210 250
Profit after tax 630 750
Income to Financiers:
Equity 630 750
Debt 160 nil
Total 790 750

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The total income available to the people who
finance G Ltd. is greater than the income
available to the people who finance E Ltd.
Some of the income has been ‘shielded’
because the interest paid to service debt is tax
allowable.
This benefit is known as the interest tax shield:

G Ltd. E Ltd.
Interest Tax Shield Value £40 Nil

Note that the value of the tax shield is

25% x Interest = 25% x £160 = £40

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The interest tax shield is an asset.
It can be valued as a perpetuity using a discounted cash
flow approach.
The appropriate discount for the tax shield depends on
the relative riskiness of the tax shield itself.
One assumption is that the risk attached to the tax
shield is identical with the risk of the interest payments
that give rise to the shield.
The interest payment of £160 in the above example
arose from interest of 4% on £4,000 debentures:
the discount rate used would therefore be 4%.
The Present Value (PV) of the tax shield is computed as
£40/0.04 = £1,000.
Effectively, the government is taking on the servicing of
25% of the loan of £4,000.

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Adopting the assumptions above there is a clear
shortcut to calculating the PV of the tax shield.
It is the product of the corporation tax rate and
the amount of the debt, DT,
where D is the amount borrowed and
T is the rate of corporation tax.
This is because the tax saving is TrD
where r is the interest rate,
and the PV of the tax shield is the tax saving
divided by the interest rate, r; thus, the PV of
the tax shield is
TrD/r = DT.

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 The Modigliani & Miller (Post-Tax)
Assumptions

• Investors are rational;

• There are no transaction costs;
• Capital markets are efficient ;
• There are equivalent firms;
• Individuals can achieve corporate gearing;
• Interest rates are independent of the level of
gearing;
• There are no costs associated with financial
distress.
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