The document discusses capital structure and cost of capital. It explains that changing a company's gearing (debt to equity ratio) can impact its weighted average cost of capital (WACC) and shareholder wealth. The traditional theory is that WACC has a U-shaped relationship with gearing, with the optimal point at the bottom of the U. Modigliani-Miller theory suggests that with no taxes, gearing is irrelevant as debt and equity costs offset, but with taxes, higher gearing lowers WACC. Betas measure risk, with asset beta measuring business risk and equity beta measuring both business and financial risk from debt. An appropriate cost of capital can be calculated by degearing and regearing

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%