19. The cost of capital (The effect of changes in gearing)

What is the traditional theory of gearing?

It has long been accepted that:

a) equity borrowing is more expensive than debt borrowing

b) higher levels of gearing increase the risk to shareholders, and therefore result in higher costs of equity

What are the implications of the traditional theory of gearing?

• Since a company should always wish to borrow in the cheapest way possible, it should raise debt finance until it achieves the optimal level of gearing

• Once the company has reached its optimal level of gearing, it should maintain that level of gearing by raising future finance part equity/part debt in such a way as to keep the optimal level of gearing unchanged

• Whilst gearing up, the company should appraise projects at the cost of the extra finance raised (the marginal cost of capital)

• Once optimal gearing has been achieved and is maintained, then projects should be appraised at the cost of the extra finance raised. However, since the WACC will remain unchanged, the cost of the extra finance will be equal to the WACC.

What is the M&M theory of gearing - ignoring taxes

In absence of taxation, WACC remains constant for all levels of gearing

They proved that although the cost of equity does indeed increase with higher gearing, it does not increase in a random way, but in such a precise way as to keep the WACC constant.

What are the implications of M&M’s theory of gearing - ignoring taxes?

• It is irrelevant how a company raises finance - the overall cost of borrowing will be unaffected

• All investments should be appraised at the WACC, however they are actually financed

• Total market value is unaffected by changes in gearing as in whichever way the company is financed the total available for distribution will be unchanged

What is M&M’s theory of getting - with tax?

The effect of corporation tax is reduce the cost of debt to the company, because of tax relief on interest payments.

Corporation tax has no effect on the cost of equity because dividends are not tax allowable.

They proved that with corporation tax, higher levels of gearing resulted in a lower WACC, due to the benefit of the tax relief of debt interest

What are the implications of M&M’s theory of gearing - with tax?

• WACC will fall with higher levels of gearing

• A company should raise as much debt as possible to get as much tax relief as possible

• Total market value increases as gearing rises as more tax relief allows for more profits to be distributed

What is the pecking order theory?

• Retained earnings

• Straight debt

• Convertible debt

• Preference shares

• Equity shares

What are the assumptions of Modiglion and Miller?

• Shareholders have perfect knowledge

• Shareholders act rationally with regard to risk

• A perfect market exists

• Debt interest is tax allowable and the company is able to get the benefit of it

• Investors are indifferent between corporate gearing and personal gearing