Chapter 3

Capital structure and

risk adjusted WACC

CAPITAL STRUCTURE AND THE COST OF CAPITAL

Does the capital structure have a bearing on shareholders wealth?

Key relationship
Future cash
‘flows
_____________
Market value =
WACC

Impact of debt financing on the WACC

Two
‘competing
‘effects

Reduction in WACC Increase in WACC

Kd < Ke, an increase in debt funding Debt introduces financial risk which increases
Should lead to a fall in WACC Ke, should lead to an increase in WACC
Debt finance is cheaper because: The risk associated with debt
1. Less risky to the investor
2. Tax efficient Financing is born by the shareholders

GEARING THEORIES
The traditional view of capital structure
Cost of capital
At relatively low level of gearing the increase in gearing will have relatively low impact on Ke. As gearing rises the impact will
increase Ke at an increasing rate.

Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high. When this level is reached the cost of debt
rises.

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Cost of
capital

Gearing (D/E)

Key point
There is an optimal level of gearing at which the WACC is minimised and the value of the company is maximised.

Modigliani and Miller (M & M) – no taxes

Cost of equity
Ke rises at a constant rate to reflect the level of increase in risk associated with gearing.
Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.

The assumptions
M & M in 1958 was based on the premise of a perfect capital market in which:
1. Perfect capital market exist where individuals and companies can borrow unlimited amounts at the same rate of interest.
2. There are no taxes or transaction costs
3. Personal borrowing is a perfect substitute for corporate borrowing.
4. Firms exist with the same business or systematic risk but different level of gearing
5. All projects and cash lows relating thereto are perpetual and any debt borrowing is also perpetual.
6. All earnings are paid out as dividend
7. Debt is risk free

Big idea
The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt. Therefore the WACC is
constant regardless of the level of gearing.

Cost Ke
of
capital
WACC

Kd

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 Gearing (D/E)
If the weighted average cost of capital is to remain constant at all levels of gearing it follows that any benefit from the use of
cheaper debt finance must be exactly offset by the increase in the cost of equity.

Modigliani and Miller – with tax

In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the added advantage of being paid
out pre-tax. The effective cost of debt will be lower as a result. The savings arising from the tax relief on debt interest are the tax
shield.

Implication
As the level of gearing rises the overall WACC falls. The company benefits from having the highest level of debt possible.

cost
of Ke
capital

WACC

Kd(1 – t)

Gearing (D/E)

Problems with high gearing

It is rare to find firms who seek to have very high gearing. This is due to problems such as:
 Bankruptcy
At higher levels of gearing there is an increasing risk of the company being unable to meet its interest payments and being
declared bankrupt. At these higher levels of gearing, the bankruptcy risk means that shareholders will require a higher return
as compensation.

 Agency costs
At higher levels of gearing there are also agency costs as a result of action taken by concerned debtholders. They are likely to
impose restrictive covenants such as restriction of future dividends or the imposition of minimum levels of liquidity in order
to protect their investment. They may also increase their level of monitoring and require more financial information.

 Tax exhaustion
As companies increase their gearing they may reach a point where there are not enough profits from which to obtain all
available tax benefits. They will still be subject to increased bankruptcy and agency costs but will not be able to benefit from
the increased tax shield.

 Loss of borrowing capacity

 Risk attitude of potential investors

Pecking order theory

A reflection that funding of companies does not follow theoretical rules but instead often follows the ‘path of least resistance’.

A suggested order is as follows:

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1st retained earnings
2nd straight debt (bank loans or bonds)
3rd convertible debt
4th preference shares
5th issue new equity shares

Limitations of pecking order theory

(a) It fails to take into account taxation, financial distress, agency costs or how the investment opportunities that are available
may influence the choice of finance.
(b) Pecking order theory is an explanation of what businesses actually do, rather than what they should do.

Impact of cost of capital on investments

The market value of a company depends on its cost of capital. The lower the company’s WACC, the higher will be the net present
value of its future cash flows and therefore the higher will be its market value.

Using the WACC in investment appraisal

The weighted average cost of capital can be used in investment appraisal if:
(a) The project being appraised is small relative to the company
(b) The existing capital structure will be maintained (same financial risk)
(c) The project has the same business risk as the company.

Arguments against using the WACC

(a) New investments undertaken by the company might have different business risk characteristics from the company’s existing
operations. As a consequence, the return required by investors might go up (or down) if the investments are undertaken,
because their business risk is perceived to be higher (or lower).

(b) The finance that is raised to fund a new investment might substantially change the capital structure and the perceived
financial risk of investing in a company. Depending on whether the project is financed by equity or by debt capital, the
perceived financial risk of the entire company might change. This must be taken into account when appraising projects.

(c) Many companies raise floating rate of debt capital as well as fixed interest debt capital. With floating rate debt capital, the
interest rate is variable, and altered every three or six months or so in line with changes in current interest market rates. The
cost of date will therefore fluctuate as market conditions vary. Floating rate debt is difficult to incorporate into a WACC
computation, and the best that can be done is to substitute an ‘equivalent’ fixed interest debt capital cost in place of the
floating rate debt cost.

CAPM IN PROJECT APPRAISAL

In project appraisal we use a cost of capital for a discount rate. Normally we can use the WACC providing that risk has not
changed.

If project risk differs to the company’s risk profile we need another way to calculate a discount rate.

The CAPM provides a means by which a project’s risk can be considered in relation to market risk.

The assumptions underpinning CAPM must hold:

1. Rational shareholders
2. Shareholders are well diversified
3. The project is an investment in its own right.

Key point
The project is assessed on its ability to earn a return in relation to its own level of risk.

Advantages over use of WACC

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1. Possible to assess all projects providing the level of risk (beta) can be determined.
2. By considering only systematic risk we have a better theoretical basis for setting a discount rate.
3. It reflects the position of large companies which are likely to be well diversified.

Limitations of using CAPM in investment appraisal

1. CAPM is a single period model, this means that the values calculated are only valid for a finite period of time and will need to be
recalculated or updated at regular intervals.

2. CAPM assumes no transaction costs associated with trading securities.

3. Any ßeta value calculated will be based on historic data which may not be appropriate currently. This is particularly so if the company has
changed the capital structure of the business or the type of business they are trading in.

4. The market return may change considerably over short periods of time.

5. CAPM assumes an efficient investment market where it is possible to diversify away risk. This is not necessarily the case meaning that
some unsystematic risk may remain.

6. Additionally the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility. As stocks
change over time it is very likely that the portfolio becomes less than optimal.

7. CAPM assumes all stocks relate to going concerns, this may not be the case.

Question 1
Toshack plc is an all equity company and has a cost of capital of 17% per annum. A new project has arisen with an estimated beta
of 1.3, rf = 10% and rm = 20%.

Required:
(a) What is the required return on the project?
(b) What relationship does this have to the cost of capital to the company?

Question 2
Johnson plc is an all equity company with a beta of 0.6. it is considering a single year project which requires an outlay now of
$2,000 and will generate cash in one year with an expected value of $2,500. The project has a beta of 1.3. rf = 10%, rm = 18%.

Required:
(a) What is Johnson’s cost of equity capital?
(b) What is the required return of the project?
(c) Is the project worthwhile?

CAPM AND FINANCIAL GEARING

So far we have assumed no gearing when calculating the level of risk for a company. If we introduce debt financing the level of
risk will rise and hence the cost of equity Ke will rise.

Differing beta values

Asset Beta (ß Financial

+
asset) gearing

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 Re - gear
De – gear

Equity beta (ß
equity) Debt
beta (ß debt)

Equity beta
A measure of risk incorporating both systematic risk and unsystematic risk.

Asset beta
A measure solely of systematic risk. The asset beta will be the same for all companies in the same industry.

Key formula (see tables)

ß asset (ungeared) = ß equity (geared) x E .
E + d(1 – t)

Question approach
1. Equity beta
Identify a suitable equity beta – we need a value from a company in the similar industry. This beta will probably include
gearing risk (if the company has any debt finance).

2. De – gear
Use the formula given to strip out the gearing risk to calculate the asset beta for the project. The asset beta will be the
same for all companies / projects in a similar industry.

3. Average asset beta

To calculate a meaning asset beta it is useful to use a simple average of a number of proxy asset betas. This way a better
assessment of the level of systematic risk suffered by the industry is calculated.

4. Re – gear
Re-work the same formula to add back the unique gearing relating to the project.

5. Use CAPM
Calculate the cost of equity using the CAPM formula

Question 3
Voronin plc is a Mastruka doll manufacturer with an equity : debt ratio of 5 : 3. The corporate debt, which is assumed to be risk

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free, has a gross redemption yield of 10%. The beta value of the company’s equity is 1.2. The average return on the stock market
is 16%. The corporation tax rate is 30%.

The company is considering a rag doll manufacturing project. K plc is a rag doll manufacturing company. It has an equity beta of
1.86 and an E:D ratio of 3:1. Volonin plc maintains its existing capital structure after the implementation of the new project.

Required:
What would be a suitable cost of capital to apply to the project?

Question 4
Toshack plc is an all equity agro-chemical firm, is about to invest in a diversification in a consumer pharmaceutical industry. Its
current equity beta is 0.8, whilst the average equity ß of pharmaceutical firms is firms is 1.3. Gearing in the pharmaceutical firms
averages 40% debt, 60% equity. Corporate debt is considered to be risk free.

Rm = 14%, Rf = 4%, corporation tax rate = 30%.

Required:
What would be a suitable discount rate for the new investment if Toshack were to finance the new project in each of the
following ways.
(a) By 30% debt;
(b) 70% equity.

Question 5
A company’s debt : equity ratio, market values, is 2 : 5. The corporate date, which is assumed to be tax-free, yields 11% before
tax. The beta value of the company’s equity is currently 1.1. The average returns on the stock market equity are 16%.

The company is now proposing to invest in a new project that would involve diversification into a new industry, and the following
information is available about the industry.

(a) Average beta coefficient of equity capital = 1.59

(b) Average debt : equity ratio in the industry = 1 : 2 (by market values)

The rate of corporation tax is 30%.

Required:
What would be a suitable cost of capital to apply to the project?

Question 6
Two companies are identical in every respect except for their capital structure. XY has a debt : equity ratio of 1 : 3, and its equity
has a β value of 1.20. PQ has a debt : equity ratio of 2 : 3. Corporation tax is 30%.

Required:
Estimate a β value for PQ’s equity

Weaknesses in the formula

(a) It is difficult to identify other firms with identical operating characteristics
(b) Estimates of beta values from share price information are not wholly accurate. They are based on statistical analysis of
historical data, and as the previous example shows, estimate using the firms’ data will differ from estimates using another
firm’s data.
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(c) There may be differences in beta values between firms caused by:
(i) Different cost structures (eg, the ratio of fixed costs to variable cost)
(ii) Size differences between firms
(iii) Debt capital not being risk-free

(d) If the firm for which the equity beta is being estimated has opportunities for growth that are recognised by investors, and
which will affect its equity beta, estimates of equity beta based on other firms’ data will be inaccurate, because the
opportunities for growth will not be allowed for.

Question 7

Backwoods is a major international company with its head office in the UK, wanting to raise $150m to establish a new production
plant in the eastern region of Germany. Backwoods evaluates its investments using NPV, but is not sure what cost of capital to use
in the discounting process for this project evaluation.

The company is also proposing to increase its equity finance in the near future for UK expansion, resulting overall in little change
in the company’s market-weighted capital gearing.

The summarised financial data for the company before the expansion are shown below.

STATEMENT OF PROFIT OR LOSS (EXTRACTS) FOR THE YEAR ENDED 31 DECEMBER 20X1
£m
Revenue 1,984
Gross profit 432
Profit after tax 81
Dividends 37
Retained earnings 44

STATEMENT OF FINANCIAL POSITION (EXTRACTS) AS AT 31 DECEMBER 20X1

£m
Non-current assets 848
Current assets 350
Total assets 1,196

Issued ordinary shares of £0.50 each nominal value 225

Reserves 761
986

Medium term and long term loans (see note below) 210
Total equity and liabilities 1,196

Note on borrowing
These include £75m 14% fixed rate bonds due to mature in five years time and redeemable at par. The current market price of
these bonds is £120 and they have an after-tax cost of debt of 9%. Other medium and long term loans are floating rate UK bank
loans at LIBOR plus 1%, with an after-tax cost of debt of 7%.

Company rate of tax may be assumed to be at a rate of 30%. The company’s ordinary shares are currently trading at 376 pence.

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The equity be beta of Backwoods is estimated to be 1.18. the systematic risk of debt may be assumed to be zero. The risk-free rate
is 7.75% and market return 14.5%.

The estimated equity beta of the main German competitor in the same industry as the new proposed plant in the eastern region of
Germany is 1.5, and the competitor’s capital gearing is 35% equity and 65% debt by book values, and 60% equity and 40% debt
by market values.

Required:
Estimate the cost of capital that the company should use as the discount rate for its proposed investment in eastern
Germany. State clearly any assumptions that you make.

Question 8

Dams Co wishes to calculate its weighted average cost of capital and the following information relates to the company at the current time.

Number of ordinary shares 20 million

Book value of 7% convertible debt $29 million
Book value of 8% bank loan $2 million
Market price of ordinary shares $5.50 per share
Market value of convertible debt $107.11 per $100 bond
Equity beta of Dams Co 1.2
Risk-free rate of return 4.7%
Equity risk premium 6.5%
Rare of taxation 30%

Dams co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be redeemed at par in eight years’
time, or converted in six years’ time into 15 shares of Dams Co per $100 bond.

Required:
(a) Calculate the market value weighted average cost of capital of Dams Co. State clearly any assumptions that you have made.
(12 marks)
(b) Discuss the circumstances under which the weighted average cost of capital can be used in investment appraisal.
(6 marks)
(c) Discuss whether the dividend valuation model or the capital asset pricing model offers the better estimate of the cost of equity of a
company. (7 marks)
(Total: 25 marks)

Question 9
LFC Co is a manufacturing company that wishes to evaluate an investment in new production machinery. The machinery would enable the
company to satisfy increasing demand for existing products and the investment is not expected to lead to any change in the existing level of
business risk of LFC co.

The machinery will cost $2.5 million, payable at the start of the first year of operation and is not expected to have any scrap value. Annual
before tax net cash flows of $680,000 per year would be generated by the investment in each of the five years of its expected operating life.
These net cash inflows are before taking account of expected inflation of 3% per year. Initial investment of $ 240,000 in working capital would
also be required, followed by incremental annual investment to maintain the purchasing power of working capital.

LFC Co has in issue five million shares with a market value of $3.81 per share. The equity beta of the company is 1.2. The yield on short-term
government debt is 4.5% per year and the equity risk premium is approximately 5% per year.

The debt finance of LFC Co consists of bonds with a total book value of $2 million. The bonds pay annual interest before tax of 7%. The par
value and market value of each bond is $100.

LFC Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation) on machinery are on a
straight-line basis over the life of the asset.

Required:
(a) Calculate the after tax weighted average cost of capital of LFC Co. (6 marks)

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(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate and comment on its net
present value. (8 marks)

(c) Explain how the capital asset pricing model can be used to calculate a project-specific discount rate and discuss the limitations of
using the capital asset pricing model in investment appraisal. (11 marks)
(Total = 25 marks)

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