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- 1. Capital structure & cost of capital
- 2. MV of a company Future cashﬂows Wacc If we can reduce this by changing gearing, then shareholder wealth increases
- 3. Impact of gearing? Should decrease WACC because debt is cheaper 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 (no tax) Debt is cheaper but cost of equity rises so WACC is constant. Gearing irrelevant.
- 6. M&M theory (with tax) Debt is cheaper and greater than the related cost of equity rises so WACC falls. Get as much debt as possible.
- 7. Betas 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 Beta
- 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 equity beta
- 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 30% B ltd: Equity:debt ratio = 2:1. Beta value 1.59
- 12. Degear the equity beta 1.59 x 2 / 2 + .7 1.18
- 13. Regear our asset beta 1.18 = ? x 5 / 5 + 1.4 = ? x 0.78 = 1.51
- 14. Cost of Equity Risk free market premium 11% + 1.51 (16%-11%) = 18.55%
- 15. Cost of debt 11% x 70% = 7.7%
- 16. WACC 18.55% x 5/7 + 7.7% x 2/7 = 15.45%

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