Gearing and the Cost of Capital


Accompanying Files
Study exercises problems
Study exercises answers

SUMMARY

The choice between debt and equity is important because this decision affects:

  • the common stockholders' expected rate of return;
  • how the rate of return varies in response to changes in economic conditions;
  • the risk of financial distress;
  • the value of the firm.

Modigliani and Miller, given certain assumptions, showed that, in the absence of all taxes, gearing made no difference. When the the tax advantage of gearing is considered, Modigliani and Miller show that the introduction of a higher proportion of debt finance will benefit shareholders. Most corporate finance officers estimate the cost of capital by determining how much debt a firm can support and, by implication, how much equity capital must be invested. The interest rate to be paid on the debt and the required rate of return demanded by shareholders on the equity can be combined to formulate an estimate of the cost of capital, in which of course - by including debt - the benefits of tax advantage have been taken into account. From a practical perspective, the numbers that can actually be used in the cost of capital calculation are necessarily approximations. The financial manager must make simplifying assumptions, looking backwards in order to speculate about the future.

LEARNING OUTCOMES

At the end of this workshop participants will have developed a balanced view of how the weighted average cost of capital and firm value are related. More specifically,  participants should be able to:

  • discuss the effect of gearing, and differentiate business and financial risk;
  • describe the underlying assumptions, rationale and conclusions of Modigliani and Miller's Models, in a world with and without taxes;
  • explain the relevance of certain important, but often non-quantifiable, influences on the optimal gearing level question.


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