1101
OVERVIEW
Objective
To understand the weighted average cost of capital (WACC) of a company and how it is
estimated.
To understand the effect of gearing on the WACC of a company.
To discuss the theories of Modigliani and Miller.
WEIGHTED
AVERAGE COST
OF CAPITAL
WEIGHTED AVERAGE
COST OF CAPITAL
AND GEARING
GEARING
Calculation of WACC
Limitations of WACC
The effects of gearing
Traditional view of capital structure
Modigliani and Miller’s theories
SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
1102
1 WEIGHTED AVERAGE COST OF CAPITAL
1.1 Calculation of WACC
Companies are usually financed by both debt and equity, i.e. they use some degree of
financial/capital gearing. We must therefore calculate a weighted average cost of
capital (WACC) which represents a company’s average cost of longterm finance. This
will give us a potential discount rate for project appraisal using NPV.
In the previous session we saw how to estimate the cost of equity and the cost of
various types of debt.
We weight the various costs of debt and equity using their respective market values.
WACC =
+ + + +
+ + + +
... D D E
... D K D K E K
2 1
2 d2 1 d1 eg
Written as
WACC =
D E
D K E K d eg
+
+
OR WACC = Keg
D E
E
+
+ Kd
D E
D
+
Where:
E = Total market value of equity
D = Total market value of debt
Keg= Cost of equity of a geared company
Kd = Cost of debt to the company (i.e. the post tax cost of debt)
In the exam the formula is given as follows:
WACC = ke
Vd Ve
Ve
(
¸
(
¸
+
+ ( ) T 1 kd
Vd Ve
Vd
−
(
¸
(
¸
+
Where:
Ve = Total market value of equity Vd = Total market value of debt
Ke = Cost of equity geared
K
d
= Pretax cost of debt T = corporation tax rate
Note that the post tax cost of debt = Kd (1 – T) for irredeemable debentures or bank loans.
If you are given a redeemable bond then you should calculate the IRR of its posttax cash
flows which directly gives you the posttax cost of debt.
SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
1103
Project has same
business risk as
existing operations
Project is financed
by existing pool of funds
Proportion of
debt to equity
does not change
A company’s current WACC is used as the discount rate only if
i.e. a company’s existing WACC can only be used as the discount rate for a potential project
if that project does not change the company’s:
Gearing level i.e. Financial Risk
Business Risk
More detail on the important concepts of Financial Risk and Business Risk is found in
the next section.
Example 1
A company has in issue:
45 million $1 ordinary shares
10% irredeemable loan stock with a book value of $55million
The loan stock is trading at par.
Share price $1.50
Dividend 15c (just paid)
Dividend growth 5% pa
Corporation tax 33%
Estimate the WACC.
Solution
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1104
1.2 Limitations of WACC
LIMITATIONS
THEORETICAL PRACTICAL
CALCULATION
OF Ke
Assumes perfect capital market
Assumes
− market value of shares
= present value of dividend stream
− market value of debt
= present value of interest/principal
Current WACC can only be used to
assess projects
which
− have similar operating risk to
that of the company
− are financed by the company’s pool
of funds, ie have same financial risk
Estimation of “g”
− historical data used to
estimate future growth rates
− Gordon’s model assumes all
growth is financed by retained
earnings
Share price may not be in
equilibrium
Ignores impact of personal
taxation
A h
CALCULATION OF Kd
Assumes constant tax rates
Bond price may not be in equilibrium
Difficulty in incorporating all
forms of long term finance, eg
BANK OVERDRAFT CONVERTIBLE
LOAN STOCK
FOREIGN LOANS
Current liability but often
has permanent core
Must be aplit between fixed and
variable element
Put fixed element in calculation
Final cash flow is uncertain
Investor has option of
(i) taking the redemption
value, or
(ii) converting into shares
Assume it will be redeemed
unless data is available to
suggest conversion
Exchange rates will
affect the value of
the loans to be
included and
interest payments
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These problems are particularly difficult for unquoted companies which have no share
price available and possibly irregular dividend payments.
In this case it may be advisable to estimate the WACC of a quoted company in the same
industry and with similar gearing and then add a (subjective) premium to reflect the
(perceived) higher risk and lower marketability of unquoted shares.
2 THE EFFECTS OF GEARING
The current WACC
reflects the current risk profile of the company: both
Business risk – The variability in the operating earnings of the company i.e. the
volatility of EBIT due to the nature of the industry
and
Financial risk – The additional variability in the return to equity as a result of
introducing debt i.e. using financial gearing. Interest on debt is a committed fixed cost
which creates more volatile bottom line profits for shareholders.
As a company gears up two things happen.
WACC = Ke E + Kd D
E + D
Ke increases due to
the increased financial
risk.
All else equal, this
pushes up the value
of WACC
The proportion of
debt relative to equity
in the capital
structure increases.
Since Kd < Ke this
pushes the value of
WACC down, all else
equal
The effect of increased gearing on the WACC depends on the relative sizes of these two
opposing effects.
There are two main schools of thought
Traditional view
Modigliani and Miller’s theories
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3 TRADITIONAL VIEW OF CAPITAL STRUCTURE
3.1 Reasoning
The traditional view has no theoretical foundation – often described as the “intuitive
approach”. It is based upon the tradeoff caused by gearing i.e. using more (relatively
cheap) debt results in a rising cost of equity. The model can also be referred to as the
“static tradeoff model”.
It is believed that K
e
rises only slowly at low levels of gearing and therefore the benefit
of using lower cost debt finance outweighs the rising K
e
.
At higher levels of gearing the increased financial risk outweighs this benefit and
WACC rises.
Cost of
capital
Ke
WACC
Kd
D/E
Optimal
gearing
Note that at very high levels of gearing the cost of debt rises. This is due to the risk of
default on debt payments i.e. credit risk.
This is referred to as financial distress risk – not to be confused with financial risk which
occurs even at relatively safe levels of debt.
3.2 Conclusions
There is an optimal gearing level (minimum WACC).
However there is no straightforward method of calculating K
e
or WACC or indeed the
optimal capital structure. The latter can only be found by trial and error.
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1107
3.3 Project finance — implications
If the company is optimally geared
Raise finance so as to maintain the existing gearing ratio
If the company is suboptimally geared
Raise debt finance so as to increase the gearing ratio towards the optimal
If the company is supraoptimally geared
Raise equity finance so as to reduce the gearing ratio back to the optimal
3.4 Approach
Appraise the project at the existing WACC
If the NPV of the project is positive the project is worthwhile
Appraise the finance
If marginal cost of the finance > WACC the finance is not appropriate and should
be rejected.
If this was the case the company could raise finance in the existing gearing ratio
and the WACC would not rise
SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
1108
4 MODIGLIANI AND MILLER’S THEORIES
4.1 Introduction
Modigliani and Miller (MM) constructed a mathematical model to provide a basis for
company managers to make financing decisions.
Mathematical models predict outcomes that would occur based on simplifying
assumptions.
Comparison of the model’s conclusions to real world observations then allows
researchers to understand the impact of the simplifying assumptions. By relaxing these
assumptions the model can be moved towards real life.
MM’s assumptions include:
Rational investors
Perfect capital market
No tax (either corporate or personal) – although they later relaxed the assumption
of no corporate tax.
Investors are indifferent between personal and corporate borrowing
No financial distress risk i.e. no risk of default even at very high levels of debt.
There is a single riskfree rate of borrowing
Corporate debt is irredeemable.
4.2 Theory without tax
MM expressed their theory as two propositions.
MM considered two companies  both with the same size and with the same level of
business risk.
One company was ungeared − Co U
One company was geared − Co G
MM’s basic theory was that in the absence of corporation tax the market values (V) and
WACC’s of these two companies would be the same. (proposition 1)
Vg = Vu
WACCg = WACCu
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1109
MM argued that the costs of capital would change as gearing changed in the following
manner:
kd would remain constant whatever the level of gearing
ke would increase at a constant rate as gearing increased due to the perceived
increased financial risk (proposition 2)
the rising ke would exactly offset the benefit of the additional cheaper debt in order
for the WACC to remain constant.
This can be shown as a graph:
Cost of
capital
WACC
D/E
Ke
Kd
Conclusion
There is no optimal gearing level;
The value of the company is independent of the financing decision
Only investment decisions affect the value of the company.
This is not true in practice because the assumptions are too simplistic. There are
differences between the real world and the model
Note that MM never claimed that gearing does not matter in the real world. They said
that it would not matter in a world where their assumptions hold. They were then in a
position to relax the assumptions to see how the model’s predictions would change.
The first assumption they relaxed was the no corporate tax assumption.
4.3 Theory with tax
When MM considered corporation tax then their conclusions regarding capital structure
were altered. This is due to the tax relief available on debt interest – the “tax shield”.
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1110
Illustration 1
Consider two companies, one ungeared, Co U, and one geared, Co G, both of
the same size and level of business risk.
Co U Co G
$m $m
EBIT 100 100
Interest − 20
____ ____
PBT 100 80
Tax @ 35% 35 28
____ ____
Dividends 65 52
____ ____
Returns to the investors:
Equity 65 52
Debt − 20
____ ____
65 72
____ ____
The investors in G receive in total each year $7m more than the investors in U.
This is due to the tax relief on debt interest and is known as the tax shield.
Tax shield = kd × D × t
where kd = pretax cost of debt
D = current market value of the debt
t = tax rate
MM assume that the tax shield will be in place each year to perpetuity and
therefore has a present value, which can be found by discounting at the rate
applicable to the debt, kd.
PV of tax shield =
kd
t D Kd × ×
= D × t
The difference in market value between G and U should therefore be that G
has a higher market value due to the tax shield and this extra value is made up
of the present value of the tax shield.
MM expressed this as:
MVg = MVu + Dt
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When corporation tax is introduced MM argue that the costs of capital will change as
follows:
Kd (the required return of the debt holders) remains constant at all levels of gearing
Ke increases as gearing levels increase to reflect additional perceived financial risk
WACC falls as gearing increases due to the additional tax relief on the debt interest.
Cost of
capital
WACC
D/E
Ke
Kd
The relationship between the WACC of a geared company, according to MM, and the
WACC (Ke) of an ungeared company is:
WACCg = Keu

.

\

+
−
D E
Dt
1
where Keu = cost of equity in an ungeared company
D = market value of debt in the geared company
E = market value of equity in the geared company
t = corporate tax rate
The formula for the cost of equity is:
Keg = Keu + (1 – T) (Keu – kd)
E
D
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1112
Illustration 1 — continued
Returning to the previous illustration these MM formulae can now be
illustrated.
Suppose that the business risk of the two companies requires a return of 10%
and the return required by the debt holders in Co G is 5%.
Co U
Market value of Co U will be the market value of the equity. This will be the
dividend capitalised at the equity holders’ required rate of return
MVu =
1 . 0
65
= $650m
Keu = 10% i.e. required rate of return for business risk (U has no financial
risk)
Co G
Market value of the equity of Co G is determined by the equity shareholders’
analysis of their net operating income into its constituent parts and the
capitalisation of those elements at appropriate rates:
MVe =
0.1
EBIT
−
0.1
35% @ Tax
−
\

0.05
Interest
−

.

0.05
35% @ relief tax
=
1 . 0
35
1 . 0
100
− −

.

−
\

05 . 0
7
05 . 0
20
= 1,000 − 350 − (400  140) = $390m
Market value of debt is determined by the debt holders capitalising their
interest at their required rate of return:
MVd =
05 . 0
20
= $400m
∴ Total market value of Co G = MVg = $390m + $400m = $790m
The MM formula that describes the relationship between the market values
of equivalent companies at various gearing levels can be illustrated here:
MVg = MVu + Dt
$790m = $650m + ($400m×35%)
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1113
MM’s WACC relationship can also be illustrated
Firstly, WACC by the usual approach:
Keg =
value Market
Dividend
=
390
52
= 13.33%
(assumes no growth in dividends)
Kd = 5% × (1 − 35%) = 3.25%
WACC = 13.33% ×
790
390
+ 3.25% ×
790
400
= 8.23%
Then by using MM/s formula: WACC = Keu (1−
D E
Dt
+
)
Keu = 10%
= 10% (1−
400 390
% 35 400
+
×
)
= 8.23%
MM’s equation for the cost of equity can also be checked
Keg = Keu + (1 – T) (Keu – kd)
E
D
= 10 + (10.35)(105)
390
400
= 13.33%, (as per the dividend valuation model above)
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1114
Conclusion
The logical conclusions to be drawn from MM’s theory with tax is that there is an
optimal gearing level and that this is at 99.9% debt in the capital structure.
This implies that the financing decision for a company is vital to its overall market
value and that companies should gear up as far as possible.
This is not true in practice; companies do not gear up to 99.9%. Why not?
In practice there are obviously many other factors that will limit this conclusion
These factors include
the risk of financial distress;
the existence of not only corporate tax but also personal taxes;
Thus in practice there are a series of factors that a company will need to consider in
deciding how to raise finance.
4.4 Practical considerations in choosing a gearing level
These will include:
business risk of the project;
existing level of financial gearing:
level of operational gearing – the proportion of fixed to variable operating costs. If
this is high then the company may not wish to use debt as this increases the level
of fixed costs even further;
type and quality of the assets;
expected growth;
personal tax position of the shareholders and debt holders.
internal and external limits to debt availability;
tax exhaustion (not enough profit to fully utilise the tax shield)
agency costs (increasingly restrictive debt covenants e.g. restricting dividends)
issue costs
asymmetry of information – potential providers of finance may overestimate the
risk of the company and refuse to provide capital at reasonable cost. Therefore the
managers may have a preference for using internal finance i.e. retained earnings,
limiting the level of gearing;
market sentiment.
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Key points
WACC estimates the company’s average cost of longterm finance.
It is therefore a potential discount rate to use for the calculation of the
NPV of possible projects. However the existing WACC should only be
used if the project would not change the company’s business risk or level
of gearing i.e. financial risk.
There are various, and conflicting, models of how financial gearing affects
the WACC – traditional tradeoff theory, Modigliani and Miller without
tax and MM with corporate tax. Each model has useful elements even if
the conclusions of such models lack practical relevance.
FOCUS
You should now be able to:
understand the weighted average cost of capital, how it is estimated and
when it should be used;
discuss the theories of Modigliani and Miller, their assumptions, implications and
limitations;
evaluate the impact of varying capital structures on the cost of capital.
SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
1116
EXAMPLE SOLUTION
Solution 1
Ke = g
Po
g) Do(1
+
+
= 05 . 0
50 . 1
05 . 1 15 . 0
+
×
= 15.5%
Kd = 10% × (1 − 0.33) = 6.67%
WACC = 15.5%
55 ) 50 . 1 45 (
55
% 67 . 6
55 ) 50 . 1 45 (
50 . 1 45
+ ×
× +
+ ×
×
× = 11.54%