Portfolio Theory, CAPM, WACC and Optimal Capital Structure

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Optimal capital structure

CareerDeal
July 2018
Strictly Private
and Confidential
20 July 2018
Agenda 1
2
An introduction to capital structure
Different measures of gearing
3
8
3 Value of an ungeared company 13
4 The traditional approach to the theory of capital structure 18
5 The Modigliani Miller approach to the theory of capital structure 24
6 Capital structure theory and CAPM 36
7 Calculating the WACC 44
8 The Adjusted Present Value approach 46
Optimal capital structure 20 July 2018

PwC 2
1 An introduction to capital structure
An introduction
to capital
structure

PwC 3
Capital structure: introduction
Gearing
Capital structure
- The extent of debt finance
- Depends on a company’s
in a company
choice between debt and
- Volatility in earnings as a
equity
result of a company’s
capital structure
Is there a mix of debt

Does capital structure Is it true that an
and equity that will
affect the company’s optimal capital
minimise the average
value? structure exists?
cost of capital?
Minimum cost of capital will maximise market value of company and

hence maximise shareholder wealth

PwC 4
Advantages of debt capital
The main advantages of debt capital centre on its relative cost. Debt capital is
usually cheaper than equity because:
The pre-tax rate of interest is invariably lower than the return required by
shareholders (due to the legal position of lenders). Debt is usually secured
on the firm’s assets, which can be sold to pay off lenders in the event of
default.
Debt interest can be set against profit for tax purposes, reducing the
effective cost.
The administrative and issuing costs are normally lower, e.g. underwriters
are not always required, although legal fees are usually involved.

PwC 5
Disadvantages of debt capital
The main downsides of debt capital centre on the additional risk to the
borrower:
Excessively high borrowing levels can lead to the risk of inability to meet
debt interest payments in years of poor trading conditions.
Shareholders are exposed to a second tier of risk above the inherent

business risk of the trading activity. Thus, rational shareholders seek
additional compensation for this extra exposure.

PwC 6
Different views on gearing
Traditional view
• In the past, it was thought advantageous to borrow so long as the company’s

capacity to service the debt was unquestioned  higher earnings per share +
higher share value
• However, excessive levels of borrowing would be forcibly articulated by the
stock market  down rating of the shares
• The so-called ‘traditional’ view of gearing centres on the concept of an optimal
capital structure which maximised company value.
The Modigliani Miller contribution
• Modigliani and Miller’s (MM, 1958) work on the pure theory of capital structure
initially suggested that company value was unaffected by gearing.
• This conclusion prompted critical opposition, leading eventually to a coherent
theory of capital structure, the current version of which looks very similar to the
traditional view.

PwC 7
2 Different measures of gearing
Different
measures of
gearing

PwC 8
Measures of gearing
Capital gearing
– the proportion of Income gearing –
debt capital in the Financial the extent to which
firm’s overall gearing the company’s
capital structure income is pre-
empted by interest
charges

PwC 9
Capital gearing – alternative measures
𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 (𝐿𝑇𝐿)

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑒𝑎𝑟𝑖𝑛𝑔 =
Problems: 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑓𝑢𝑛𝑑𝑠
1. Market value of equity may be higher than the book value.

2. Lack of an upper limit to the ratio, hindering intercompany comparisons 
can be mitigated by expressing LTL as a fraction of all long-term finance.
3. Provisions made out of previous years’ income may be written back into
profits and hence, equity in later years. Adjusted to exclude provisions,
long-term borrowings can replace LTL in the equation.
Short-term borrowings may not always feature in the formula: they may be
volatile and they could be offset against holdings of cash and highly liquid
marketable securities to yield a measure of net debt.
Practical formula:
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑒𝑎𝑟𝑖𝑛𝑔 =
𝑇𝑜𝑡𝑎𝑙 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 Net debt + Total equity

PwC 10
Interest cover and income gearing
• The inability to make interest payments could lead to a debt crisis.

• The size and reliability of the company’s income in relation to its interest
commitments is therefore an important consideration.
• The ability of a company to meet its interest obligations is usually measured
by the ratio of profit before tax and interest, to interest charges, known as
interest cover:
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑟𝑔𝑒𝑠
• The income gearing ratio indicates the proportion of pre-tax earnings

committed to prior interest charges (normally expressed as a %):
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑟𝑔𝑒𝑠
𝐼𝑛𝑐𝑜𝑚𝑒 𝑔𝑒𝑎𝑟𝑖𝑛𝑔 = × 100
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

PwC 11
The Company’s capital structure
Equity Debt
Cost of equity: Ke Cost of debt: Kd

• Calculated through CAPM or • Calculated through valuation
Dividend Growth Model of bonds, interest rate net of
Required return: tax…
• Risk-free rate of return Required return:
• Premium for business risk • Cost of debt – Kd
(risk associated with a
company’s profits & earnings
varying due to systematic
influences on that company’s
business sector)

PwC 12
3 Value of an ungeared company
Value of an
ungeared
company

PwC 13
Value of an ungeared company (1 of 3)
• For an ungeared company, market value is found by discounting (or

capitalising) its stream of annual earnings, E, at the rate of return required
by shareholders, ke.
• The value of an ungeared company, Vu, is simply the value of the
ordinary shares, Vs.
• For a constant and perpetual stream of annual earnings, E:
𝐸 so that 𝐸
𝑉𝑢 = 𝑉𝑠 = 𝑘𝑒 =
𝐾𝑒 𝑉𝑠
• Gearing splits the earnings stream of the company into two components:
• the prior interest charge; and
• the portion attributable to shareholders, the net income (NI) of (E – iB).
• The overall value of the company is the value of the shares (Vs) plus the value
of the debt, each capitalised at its respective rate of discount.

PwC 14
• For debt, where there is no discrepancy between book value (B) and market
value (VB) the capitalisation rate is simply the nominal interest rate.
• The overall value of the geared company, Vg, is the combined value of its
shares and its debt:
(𝐸 − 𝑖𝐵) 𝑖𝐵 𝐸 − 𝑖𝐵
𝑉𝑔 = 𝑉𝑠 + 𝑉𝐵 = + = + 𝑉𝐵
𝑘𝑒 𝑖 𝑘𝑒
• The overall capitalisation rate (denoted by k0) for a company using a mixed
capital structure is a weighted average, whose weights reflect the
relative importance of each type of finance in the capital structure, i.e. Vs/Vg
and VB/Vg for equity and debt, respectively:
𝑉𝑠 𝑉𝐵
𝑘0 = 𝑘𝑒 𝑥 + 𝑖𝑥
𝑉𝑔 𝑉𝑔

PwC 15
• Bearing in mind that (keVs) and iB (or iVB, when VB=B) represent the
returns to shareholders and lenders respectively, together E, the weighted
average expression simplifies to:
𝑘𝑒𝑉𝑠 + 𝑖𝐵 𝐸
𝑘0 = =
𝑉𝑔 𝑉𝑔
• For both ungeared and geared firms alike, k0 is found by dividing the total
required earnings by the value of the whole firm.
• k0 = weighted average cost of capital (WACC)  expresses the overall
return required to satisfy the demands of both groups of stakeholders.
• The WACC may be interpreted as an average discount rate applied by the
market to the company’s future operating cash flows to derive the capitalised
value of this stream, i.e. the value of the whole company.

PwC 16
Different views on the theory of capital structure
01 There is an optimal capital structure

that maximises the value of the
Traditional view company
02 Initially, capital structure should not

have an impact on company value, but
Miller and after adjusting for company
Modigliani view imperfections, an optimal capital
structure may be reached

PwC 17
4 The traditional approach to the theory of capital structure
The traditional
approach to
the theory of
capital
structure

PwC 18
The traditional approach (1 of 3)
Cost of
capital Ke
(%)
WACC
Kd
Optimal capital structure
0
Level of gearing

PwC 19
Note: ke rises
before kd given
that equity has a
higher risk
Source: Pike and Neale, 6th Ed.

PwC 20
• In the traditional view of gearing, shareholders are deemed unlikely to

respond adversely (if at all) to minor increases in gearing so long as the
prospect of default looks remote.
• If ke remains static, substitution of debt for equity will lower the
overall cost of capital. Corresponding to this fall in k0 is an increase in
the value of the whole geared company, Vg, in relation to that of an
equivalent ungeared company, Vu.
• At some point, shareholders will become concerned by the greater financial
risk to which their earnings are exposed and begin to seek higher returns. In
addition, providers of additional debt are likely to raise their requirements as
they perceive the probability of default increasing.
• The WACC profile will eventually be forced to rise, and the value of
the company will fall. The model involves a clear optimal debt/equity
mix, where company value is maximised and the WACC is
minimised.
PwC 21
• However, the traditional approach fails to identify a specific optimal

gearing ratio for all firms in all circumstances.
• The optimal ratio is likely to depend on the nature of the industry (e.g.
whether the activity generates strong cash flows), the general marketability
of the company’s assets, expectations about the prospects for the industry,
and the general level of interest rates.
• In practice, companies have a target capital structure which they usually
adhere to even when funding new projects.

PwC 22
The cost of debt
• Corporate bond values behave in a similar way to the market prices of

government stock: a rise in general market interest rates leads to bond
dealers marking down the value of existing stocks until they offer the same
yield investors can obtain by purchasing new issues.
• Equilibrium in the bond market is achieved when all stocks that are subject
to the same degree of risk and that have the same period to
redemption offer the same yield.
𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛 𝑖𝑟𝑟𝑒𝑑𝑒𝑒𝑚𝑎𝑏𝑙𝑒 𝑏𝑜𝑛𝑑 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑥
𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑎𝑡𝑒
• There are tax benefits associated with using debt. The value of the tax savings
on interest payments, or the ‘tax shield’, is calculated as follows:
Tax shield = interest charge x (tax rate) x PVIF

PwC 23
5 The Modigliani Miller approach to the theory of capital
structure
The Modigliani
Miller approach to
the theory of
capital structure

PwC 24
structure
The Modigliani Miller approach
• MM contended that, in a perfect capital market, the value of a company

depended simply on its income stream and the degree of business risk,
regardless of its capital structure.
• Therefore, any imbalance between the value of a geared company and an
otherwise identical ungeared company could only be temporary and would
be quickly unwound by market forces.
• The mechanism for equalising the values of companies, identical except for
their respective gearing, was the process of ‘arbitrage’, a feature of all
developed financial markets which ensures that assets with the same risk–
return characteristics sell at the same prices.

PwC 25
structure
Modigliani and Miller’s assumptions
01
All investors 02
are price-
takers.
08
03
Investors
have similar MM’s No personal
expectations or corporate
about future
assumptions income
earnings. taxes.
07 No
Firms can be
grouped into brokerage 04
‘homogeneous or other
risk classes’. Investors are transaction
all rational charges.
06 wealth
05
seekers.
PwC 26
structure
MM Proposition I
• The central proposition is that a firm’s WACC is independent of its

debt/equity ratio, and equal to the cost of capital that the firm would
have with no gearing in its capital structure.
• The appropriate capitalisation rate for a firm is the rate applied by the
market to an ungeared company in the relevant risk category, i.e. that
company’s cost of equity.
• The arbitrage mechanism will operate to equalise the values of any two
companies whose values are temporarily out of line with each other.
• MM concluded that both company value and the overall required return
(k0), are independent of capital structure.

PwC 27
structure
MM Proposition II
• The expected yield of a share of equity is equal to the appropriate

capitalisation rate, ke, for a pure equity stream in the class, plus a
premium related to the financial risk equal to the debt/equity ratio
times the spread between ke and kd.
𝑉𝐵
𝑘𝑒𝑔 = 𝑘𝑒𝑢 + 𝑘𝑒𝑢 − 𝑘𝑑 𝑥
𝑉𝑠
where:
• keg = returns required by shareholders of a geared company
• keu = returns required by shareholders of an ungeared company
• The rate of return required by shareholders increases linearly as the
debt/equity ratio is increased, i.e. the cost of equity rises exactly in line with
any increase in gearing to offset precisely any benefits conferred by the use of
apparently cheap debt.
• In the MM view, shareholders respond immediately when any gearing
is undertaken, i.e. to them, any use of debt introduces an element of risk.
PwC 28
structure
MM Propositions I and II

PwC 29
structure
MM Proposition III
• MM’s third proposition asserts that ‘the cut-off rate for new investment
will in all cases be the WACC and will be unaffected by the type of
security used to finance the investment’.
• Proposition I states that the WACC is constant and equal to the cost of equity
in an equivalent ungeared company. Since it is invariant to capital structure,
it follows that however a project is financed, it must yield a return of at least
the overall minimum return required to satisfy stakeholders as a whole.

PwC 30
structure
MM with corporate income tax (1 of 5)
• Taking tax into consideration, the value of a geared company’s shares

becomes the capitalised value of the after-tax earnings stream (net income):
(𝐸 − 𝑖𝐵)(1 − 𝑇)
𝑉𝑠 =
𝑘𝑒𝑔
• Assuming that the book and market values of debt capital coincide so that
the cost of debt, kd, equates to the coupon rate, i, the value of debt is the
discounted interest stream, i.e. VB= iB/i. The value of the whole company is
thus:
(𝐸 − 𝑖𝐵)(1 − 𝑇) 𝑖𝐵
𝑉0 = 𝑉𝑠 + 𝑉𝐵 = +
𝑘𝑒𝑔 𝑖
• Geared companies will sell at a premium over equivalent

ungeared companies because of the benefits of tax-allowable debt
interest.

PwC 31
structure
• The post- tax annual expected earnings stream, comprises the earnings
attributable to shareholders plus the debt interest:
𝐸𝑇 = 𝐸 − 𝑖𝐵 1 − 𝑇 + 𝑖𝐵 or 𝐸𝑇 = 𝐸 1 − 𝑇 + 𝑇𝑖𝐵
• The first element is the net income that the shareholders in an equivalent
ungeared company would receive, while the second element is the annual
tax benefit afforded by debt interest relief.
• The total value of the geared company, Vg, is found by capitalising the first
element at the cost of equity capital applicable to an ungeared company (keu)
while the second is capitalised at the cost of debt, which we have assumed
equals the nominal rate of interest, i:
𝐸(1 − 𝑇) 𝑇𝑖𝐵 𝐸(1 − 𝑇)
𝑉𝑔 = + = = 𝑉𝑢 + 𝑇𝐵
𝑘𝑒𝑢 𝑖 𝑘𝑒𝑢
• The discounted value of future tax savings, or the tax shield, is thus a major
modification of MM’s Proposition I.
PwC 32
structure
• With no corporate tax, Proposition II stated that the shareholders in a geared

company require a return, keg, of:
𝑉𝐵
𝑘𝑒𝑔 = 𝑘𝑒𝑢 + 𝑘𝑒𝑢 − 𝑘𝑑 𝑥
𝑉𝑠
• However, in a taxed world, the return required by shareholders becomes:
𝑉𝐵
𝑘𝑒𝑔 = 𝑘𝑒𝑢 + 𝑘𝑒𝑢 − 𝑘𝑑 (1 − 𝑇) 𝑥
𝑉𝑠
• The return required by the geared company’s shareholders is now the cost
of equity in an identical ungeared company plus a financial risk
premium related to the corporate tax rate and the debt/equity
ratio.
• If, at every level of gearing, the cost of equity is lower and also the cost of
debt itself is reduced by interest deductibility, the WACC (k0) is lower at all
gearing ratios, and declines as gearing increases.

PwC 33
structure

PwC 34
structure
• The tax advantage of debt financing is incorporated in the revised equation

for the WACC:
𝑉𝑠 𝑉𝐵 𝑇𝑥𝑉𝐵
𝑘0 = 𝑘𝑒𝑔 𝑥 + 𝑖 1−𝑇 𝑥 𝑘0 = 𝑘𝑒𝑢 1 −
𝑉𝑠 + 𝑉𝐵 𝑉𝑠 + 𝑉𝐵 or 𝑉𝑠 + 𝑉𝐵
• In its tax-adjusted form, the MM thesis looks rather more like the traditional
version, in so far as the WACC declines over some range of gearing.
• However, the benefits from gearing clearly derive from the tax
system, rather than from the apparent failure of the shareholders to
respond fully to financial risk by seeking higher returns.

PwC 35
6 Capital structure theory and CAPM
Capital structure
theory and CAPM

PwC 36
Capital structure theory and the CAPM (1 of 2)
• A feature of MM’s initial model was the classification of firms into

‘homogeneous risk classes’ as a way of controlling for inherent operating or
business risk. The modern distinction between systematic and specific risk
makes this unnecessary, as relevant business risk is expressed by the Beta.
• The key point is that gearing introduces additional risk (and therefore,
increases the equity Beta) so that shareholders require additional
compensation.
• CAPM formula:
𝑘𝑒𝑔 = 𝑅𝑓 + 𝛽𝑔(𝐸𝑅𝑚 − 𝑅𝑓)
• Moreover,
𝑉𝑠
𝛽𝑢 = 𝛽𝑔 𝑥
𝑉𝑠 + 𝑉𝐵(1 − 𝑇)
• The shareholders of a geared company seek compensation for two types of
risk: the underlying or basic risk of the business activity, and financial risk.
PwC 37
Capital structure theory and the CAPM (2 of 2)

PwC 38
Ungearing and re-gearing Beta (1 of 2)
• The asset Beta (i.e. the activity Beta) equals the Beta of the methods of
finance used to acquire those assets, i.e., the asset Beta equates to a weighted
average of the Betas of the various methods of financing, according to the
importance of each source of finance in the capital structure.
𝐵𝑒𝑡𝑎 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠
= 𝐸𝑞𝑢𝑖𝑡𝑦 𝐵𝑒𝑡𝑎 𝑥 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 𝐵𝑒𝑡𝑎 𝑥 𝑝𝑟𝑜𝑝𝑜𝑟𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑉𝑠 𝑉𝐵
𝛽𝐴 = 𝛽𝑠 𝑥 + 𝛽𝐵 𝑥
𝑉𝑠 + 𝑉𝐵(1 − 𝑇) 𝑉𝑠 + 𝑉𝐵(1 − 𝑇)
• When moving into a new activity we can take a firm’s equity Beta
and ungear it to reveal the underlying activity Beta.
• This is particularly useful when diversifying into a new activity – we might
borrow a Beta from another firm, whose gearing may differ from our own.
• In this case, we might ungear the borrowed Beta to strip out that firm’s
financial risk, and then re-gear to incorporate our own firm’s gearing ratio.
PwC 39
Ungearing and re-gearing Beta (2 of 2)
Example:
• Equity Beta of firm operating in new activity = 1.35
• Gearing ratio (debt/ equity) of firm = 40%
• Tax rate = 30%
• Own gearing ratio = 10% (debt/ equity)
Ungearing the other firm’s equity Beta, assuming the debt Beta is zero:
𝑉𝑠 60
𝛽𝐴 = 𝛽𝑠 𝑥 = 1.35 x = 0.92
𝑉𝑠 + 𝑉𝐵(1 − 𝑇) 60 + 40(1 − 30%)
Re-gearing to incorporate the company’s own gearing, the βs is given by:
100
0.92 = 𝛽𝑠 𝑥
100 + 10(1 − 30%)
107
𝛽𝑠 = 0.92 𝑥 = 0.98
100
PwC 40
MM with financial distress (1 of 3)
• Few companies gear up to extreme levels, through both their own and
lenders’ fear of insolvency, and its associated costs. MM’s omission of
liquidation costs from their analysis was a logical consequence of their
perfect capital market assumptions.
• However, liquidation costs and the other costs of financial distress
introduce a new imperfection into the analysis of capital structure decisions:
namely the actual or expected inability to realise ‘full value’ for assets in a
distress sale and the costs of actions taken to forestall this contingency.
• Denoting the ‘costs of financial distress’ by FD, the value of a geared
company becomes:
𝑉𝑔 = 𝑉𝑢 + 𝑇𝐵 − 𝐹𝐷
• The financial manager should attempt to maximise the gap between

tax benefits and financial distress costs, i.e. (TB – FD).
• There exists an optimal capital structure where company value is
maximised  where MB of further tax savings = MC of anticipated FD.
PwC 41
• The costs of financial distress rise with gearing once the market starts to
perceive a substantially increased risk of financial failure.
• For most companies, the probability, p, of financial distress will increase
with the book values of debt, B, so that the FD function increases with
gearing. If d denotes the expected percentage discount on the pre-liquidation
value in the event of a forced sale, the expected costs of financial distress are:
𝐹𝐷 = 𝑝 𝑥 𝑑 𝑥 𝑉𝑔
and the value of the geared firm becomes:

𝑉𝑔 = 𝑉𝑢 + (𝑇𝐵 − 𝑝 𝑥 𝑑 𝑥 𝑉𝑔 )
• This suggests that market imperfections can be exploited to raise

company value so long as TB exceeds FD. The inverted U-shaped value
profile now appears remarkably similar to the traditional version and, thus,
is associated with a mirror-image WACC schedule.
PwC 42

PwC 43
7 Calculating the WACC
Calculating
the WACC

PwC 44
7 Calculating the WACC
Calculating the WACC
• The WACC is the overall required return needed to satisfy all stakeholders.
Example:
• Value of debt = VB = €1m
• Value of equity = Vs = €2.80m
• Shareholders’ required return = keg = 22.5%
• Interest cost of debt = i = 10%
• Rate of corporate tax = T = 30%
𝑉𝑠 𝑉𝐵
𝑊𝐴𝐶𝐶 = 𝑘𝑒𝑔 𝑥 + 𝑖 1−𝑇 𝑥
𝑉𝑠 + 𝑉𝐵 𝑉𝑠 + 𝑉𝐵
€2.80𝑚 €1𝑚
= 22.5% 𝑥 + 10%(1 − 30%) 𝑥
€2.80𝑚 + €1𝑚 €2.80𝑚 + €1𝑚
= 22.5% 𝑥 0.74 + 7% 𝑥 0.26 = 16.6% + 1.8% = 18.4%

PwC 45
8 The Adjusted Present Value approach
The Adjusted
Present Value
approach

PwC 46
The Adjusted Present Value (1 of 3)
• The adjusted present value (APV) of a project is simply the ‘essential’

worth of the project, adjusted for any financing benefits (or costs)
attributable to the particular method of financing it.
• This method is valid only so long as the WACC profile is declining due to the
value of the tax shield.
Evaluate the ‘base case’ NPV, discounting at the rate
of return that shareholders would require if the project
β Step 1 were financed wholly by equity. This rate is derived by
ungearing the company’s equity Beta.
Evaluate separately the cash flows attributable to the
financing decision (inc. costs and benefits associated
Step 2 with the project), discounting at the appropriate risk-
adjusted rate.
Add the present values derived from the two
previous stages to obtain the APV. The project is
Step 3
acceptable if the APV is greater than zero.

PwC 47
Example:
Rigton plc has a debt/equity ratio of 20%. The equity Beta is 1.30. The risk-free
rate is 10% and a return of 16% is expected from the market portfolio. The rate
of corporate tax is 30%. Rigton proposes to undertake a project requiring an
outlay of €10 million, financed partly by equity and partly by debt. The project,
a perpetuity, is thought to be able to support borrowings of €3 million at an
interest rate of 12%, thus imposing interest charges of €0.36 million. It is
expected to generate pre-tax cash flows of €2.3 million p.a.
Solution:
1. Calculate the ungeared beta
𝑉𝑠 100% 1.30
𝛽𝑢 = 𝛽𝑔 𝑥 = 1.30 𝑥 = = 1.14
𝑉𝑠 + 𝑉𝐵(1 − 𝑇) 100% + 20%(1 − 30%) 1.14

PwC 48
2. Calculate the cost of equity through CAPM
𝐸𝑅𝑗 = 𝑅𝑓 + 𝛽𝑢 𝐸𝑅𝑚 − 𝑅𝑓 = 10% + 1.14 16% − 10% = 0.10 + 0.068

= 0.168 = 16.8%
3. Calculate the NPV
€2.3𝑚(1 − 30%) €1.61𝑚

𝑁𝑃𝑉 = −€10𝑚 + = −€10𝑚 + = −€10𝑚 + €9.58𝑚
16.8% 0.168
= −€0.42𝑚

PwC 49
Thank you!
© 2018 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC
refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm
is a separate legal entity. Please see www.pwc.com/structure for further details. This document is for
general information purposes only, and should not be used as a substitute for consultation with
professional advisors.

Portfolio Theory, CAPM, WACC and Optimal Capital Structure

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Portfolio Theory, CAPM, WACC and Optimal Capital Structure

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Optimal capital structure

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

Capital structure: introduction

Is there a mix of debt

Minimum cost of capital will maximise market value of company and

Optimal capital structure 20 July 2018

Advantages of debt capital

Optimal capital structure 20 July 2018

Disadvantages of debt capital

Shareholders are exposed to a second tier of risk above the inherent

Optimal capital structure 20 July 2018

Different views on gearing

• In the past, it was thought advantageous to borrow so long as the company’s

The Modigliani Miller contribution

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

Capital gearing – alternative measures

𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 (𝐿𝑇𝐿)

1. Market value of equity may be higher than the book value.

Optimal capital structure 20 July 2018

Interest cover and income gearing

• The inability to make interest payments could lead to a debt crisis.

• The income gearing ratio indicates the proportion of pre-tax earnings

Optimal capital structure 20 July 2018

The Company’s capital structure

Cost of equity: Ke Cost of debt: Kd

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

Value of an ungeared company (1 of 3)

• For an ungeared company, market value is found by discounting (or

Optimal capital structure 20 July 2018

Value of an ungeared company (2 of 3)

Optimal capital structure 20 July 2018

Value of an ungeared company (3 of 3)

Optimal capital structure 20 July 2018

Different views on the theory of capital structure

01 There is an optimal capital structure

02 Initially, capital structure should not

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

The traditional approach (1 of 3)

Optimal capital structure

Optimal capital structure 20 July 2018

The traditional approach (2 of 4)

Source: Pike and Neale, 6th Ed.

Optimal capital structure 20 July 2018

The traditional approach (3 of 4)

• In the traditional view of gearing, shareholders are deemed unlikely to

The traditional approach (4 of 4)

• However, the traditional approach fails to identify a specific optimal

Optimal capital structure 20 July 2018

The cost of debt

• Corporate bond values behave in a similar way to the market prices of

Tax shield = interest charge x (tax rate) x PVIF

Optimal capital structure 20 July 2018

Optimal capital structure 20 July 2018

The Modigliani Miller approach

• MM contended that, in a perfect capital market, the value of a company

Optimal capital structure 20 July 2018

Modigliani and Miller’s assumptions

• The central proposition is that a firm’s WACC is independent of its