Capital structure and wacc

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  • Capital structure and wacc

    1. 1. Capital structure & cost of capital
    2. 2. MV of a company Future cashflows Wacc If we can reduce this by changing gearing, then shareholder wealth increases
    3. 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. 4. Traditional Theory WACC is U shaped. So find optimal point at bottom and keep gearing at that level
    5. 5. M&M theory (no tax) Debt is cheaper but cost of equity rises so WACC is constant. Gearing irrelevant.
    6. 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. 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. 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. 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. 10. Degearing formula Ba = Be x MV of equity MV of equity + MV of debt (tax adjusted)
    11. 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. 12. Degear the equity beta 1.59 x 2 / 2 + .7 1.18
    13. 13. Regear our asset beta 1.18 = ? x 5 / 5 + 1.4 = ? x 0.78 = 1.51
    14. 14. Cost of Equity Risk free market premium 11% + 1.51 (16%-11%) = 18.55%
    15. 15. Cost of debt 11% x 70% = 7.7%
    16. 16. WACC 18.55% x 5/7 + 7.7% x 2/7 = 15.45%

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