2. MV of a company
If we can reduce this by changing
gearing, then shareholder wealth
3. Impact of gearing?
Should decrease WACC because debt is
Should increase WACC because more debt
means more risk to shareholders and so
increase cost of equity
4. Traditional Theory
WACC is U shaped. So ﬁnd optimal point at
bottom and keep gearing at that level
5. M&M theory
Debt is cheaper but cost of equity rises so
WACC is constant. Gearing irrelevant.
6. M&M theory
Debt is cheaper and greater than the
related cost of equity rises so WACC falls.
Get as much debt as possible.
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
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
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
10. Degearing formula
Ba = Be x MV of equity
MV of equity + MV of debt (tax adjusted)
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
B ltd: Equity:debt ratio = 2:1. Beta value 1.59
12. Degear the equity beta
1.59 x 2 / 2 + .7
13. Regear our asset beta
1.18 = ? x 5 / 5 + 1.4
= ? x 0.78