FINANCIAL MANAGEMENT

Chapter 6

Capital Structure
Chapter Topic List
Capital structure
Modigliani and Miller (M&M) 1958 & 1963

Capital structure and high gearing

Adjusted present value
Gearing and the CAPM
 Learning Objectives
 To explain and illustrate what is meant by
financial risk
 To explain the traditional view of gearing
 To explain the M & M view of gearing
 To outline the key aspects of capital structure
 Capital structure
Business and financial risk (Definitions)
• Business risk is the variability in earnings before
interest and tax associated with the industrial sector in
which a firm operates.
• It is determined by general business and economic
conditions.
• Well-diversified shareholders will only be interested in
risk that cannot be diversified away, i.e. the systematic
element of business risk ('systematic business risk').
 Capital structure
Business and financial risk (Definitions)
Financial risk is the additional variability in
returns as a result of having fixed interest debt
in the capital structure. Equity holders take this
risk in particular, but debt holders also suffer
financial risk at high gearing levels.
 Self-test 01
Which of the following events is most likely to lead to an
increase in a firm's operating risk?
a) An increase in the proportion of the firm's operating
capital which is debt
b) An increase in the proportion of the firm's operating
capital which is equity
c) An increase in the proportion of the firm's operating
costs which are variable
d) An increase in the proportion of the firm's operating
costs which are fixed
 Answer to Self-test 01
• Answer: D
• Operating risk is independent of the
debt/equity ratio.
 Self-test 02
If for a given level of activity a firm's ratio of variable
costs to fixed costs were to rise and, at the same time,
its ratio of debt to equity were to fall, what would be
the impact on the firm's financial and operating risk?
Financial risk Operating risk
a) Increase Increase
b) Decrease Increase
c) Increase Decrease
d) Decrease Decrease
 Answer to Self-test 02
• Answer: D
• Financial risk is dependent on the debt/equity
ratio: the higher its value the greater is the
financial risk.
• Operating risk is dependent on the ratio of
variable costs to fixed costs: the higher its
value the lower is the operating risk.
 Gearing
Operating gearing (or risk) is the extent to which
a firm's operating costs are fixed, as opposed to
variable.
Firms with high operating gearing, e.g. steel
plants, oil refineries, have high break-even points
and earnings before interest and tax (EBIT) which
are very sensitive to changes in sales.
Operating gearing is linked to business risk.
 Gearing (cntd)
Financial gearing is the extent to which debt is
used in the capital structure. This can be
measured in two ways:
Worked Example: Demonstration of Gearing
 Worked Example-Demonstration of Gearing: Solution

The following shows an abbreviated statement for a

financially geared firm before and after a 10% decrease
in sales and a 10% increase in sales.
Worked Example-Demonstration of Gearing: Solution (cntd)

• Returns
  are enhanced when sales increase but
the position is reversed when sales fall.
• Financial gearing affects the volatility of equity
earnings and, therefore, requires a premium
to be reflected in the cost of equity.
• This can be seen in the 26 % change in EBIT
and the 80% change in earnings before tax
created by only a 10% change in sales.
What Happens if Gearing Changes?

The effect of increased gearing on the WACC depends on the

relative sizes of these two opposing effects.
So how, precisely, does the gearing affect the WACC and,
therefore, shareholder wealth?
 Traditional View of Gearing
• The traditional view is that as an organization introduces
debt into its capital structure, the weighted average cost of
capital will fall, because initially the benefit of cheap debt
finance outweighs any increases in the cost of equity
required to compensate equity holders for higher financial
risk. Initially, there is very little change in the shareholders'
required returns.
• As gearing continues to increase, the equity holders will ask
for progressively higher returns and eventually this increase
will start to outweigh the benefit of cheap debt finance, and
the weighted average cost of capital will rise.
 Traditional View of Gearing (cntd)
• At extreme levels of gearing the cost of debt will
also start to rise (as debt holders become worried
about the security of their loans) and this will also
contribute to an increasing weighted average cost of
capital.
• There is an optimal level of gearing at which the
value of the firm's equity plus debt is maximized. This
occurs at the point where the WACC is minimized.
 Traditional View of Gearing (cntd)
• There is no precise method of calculating ke or WACC, or
indeed the optimal capital structure. The latter needs to be
found by trial and error by changing the gearing and seeing
how the market responds
• If simplifying assumptions are made (i.e. that both interest
and dividends are constant perpetuities and debt is
irredeemable), then

Given any set of earnings, if the lowest WACC is maintained,

projects will have the highest NPV (at the lowest discount
rate) and shareholder wealth will be maximized.
 Modigliani and Miller (M&M) 1958 &
1963: Overview

• In 1958 and 1963 M&M published papers on capital

structure which were at odds with the traditional
approach.
• In a no-tax world, there is no optimum gearing level.
• In a taxed world debt is a tax efficient way to finance
a business.
 M&M 1958

M&M showed in 1958 that with no

corporation tax there is no advantage for
firms to issue debt (gear up)
Worked Example: Capital structure (Ignoring
Effect of Tax)
• A company generates EBIT (earnings before interest
and tax) of CU100m. It currently has no debt in the
capital structure. It is considering the use of debt,
and is exploring of raising CU800 million or CU1,800
million. Interest is payable at 5%.
• Requirement
Ignoring taxation and assuming all earnings after
interest are paid out as dividends, find out which is
the most attractive capital structure.
Worked Example: Capital Structure -
Solution
Worked Example: Capital Structure –
Solution (cntd)
 Worked Example: Capital Structure –
Solution (cntd)

• This suggests that there is no optimal level of gearing. The

benefits of cheap debt finance are exactly offset by the
increased returns required by shareholders for the extra
financial risk – the cost of equity rises in direct proportion to
the increased gearing.
• In the traditional view it was felt that at lower gearing levels
the increase in required return was less than proportional.
The result of this is that under the traditional view the WACC
falls at low gearing levels.
 M&M 1963

• M&M showed in 1963 that, in the presence of

corporation tax, it is advantageous for firms to
issue debt (gear up).
• The concept of homemade leverage
Interactive Question 1: Capital Structure
with Effect of Taxation
Answer to Interactive Question 1
 Answer to Interactive Question 1

The extra distributions arise because of the corporation tax savings on debt
interest. For example, in the 2nd scenario, paying CU40m interest saves
CU40m × 30% = CU12m tax (which is the difference between the tax bills of
CU30m and CU18m in the first and second columns). This gives rise to the
extra CU12m distributed (CU82m – CU70m).

The more highly geared a firm, the greater should be its total distributions.
Therefore the firm should become more valuable as gearing increases.
Modigliani and Miller (M&M) 1958 & 1963:
Conclusion
• The effect of interest being allowable against
tax means that geared companies pay less tax.
This means geared companies will have more
cash to pay out to investors, and therefore are
worth more. The optimal capital structure is
therefore a geared one.
• More formally M&M showed in 1963 that:
Modigliani and Miller (M&M) 1958 & 1963:
Implications
• The implication is that the WACC falls as the
gearing level rises.
• Here the benefits of the tax relief mean that
increasing amounts of debt reduce the WACC
and this is less than offset by the increasing
returns required by shareholders which push up
the WACC, i.e. overall the WACC declines.
• This suggests that the optimal level of gearing is
nearly 100% debt.
 Capital Structure and High Gearing:
Overview
• High gearing as advocated by M&M has some
problems with it, there being bankruptcy
costs, agency costs and tax exhaustion.
• Managers can act in ways which prefer
shareholders to debtholders and so increase
bankruptcy costs.
• Lenders use loan covenants to protect their
position.
 Problems Associated with High Levels of
Gearing
• A brief examination of company balance
sheets would reveal that in reality companies
do not use 100% debt gearing levels. The
reasons for this are usually categorised as
follows:
(a) Bankruptcy costs
(b) Agency costs
(c) Tax exhaustion
 Bankruptcy Costs
The basic M&M with-tax equation is

As firms take on higher levels of gearing, the chances of default on

debt repayments, and hence liquidation ('bankruptcy'), increase.
Investors will be concerned over this and sell their holdings, which
will cause the value of the company's securities to fall, with a
corresponding increase in the firm's cost of funds.
To optimize capital structure, financial managers must therefore
not increase gearing beyond the point where the cost of investor
worries over bankruptcy outweighs the benefits gained from the
increased tax shield on debt.
 Bankruptcy Costs
• If a firm is liquidated, its assets are usually sold at less than their
going-concern value. Liquidation costs and distress prices for assets
can all lead to assets realizing less than their economic value.
• These costs mean that the company's going concern value will be
greater than its winding-up value. This loss in value will often be
borne by the finance providers in the event of bankruptcy.
• To compensate for this, investors in both debt and equity will ask
for higher rates of return from highly-geared companies and thus
drive down the prices for their securities.
• These costs can be suffered by companies that eventually go
bankrupt or by those that are close to bankruptcy for many years.
Interactive Question 2: Acceptable Debt
Levels
 Answer to Interactive Question 2
• In highly-geared firms managers may find that the bulk of
their time and attention is spent on keeping creditors
happy, rather than on seeking the best course of action for
the future prosperity of the firm.
• For example, it may make good financial sense to dispose
of a surplus asset and use the funds to finance a profitable
area of operations.
• However, if this means a loss of collateral for the creditors,
much time can be wasted in persuading them to allow the
asset to be sold. These operating problems will reduce the
future cash flows of the business and hence its value.
Answer to Interactive Question 2 (cntd)
• Additionally, the firm may find that key employees leave rather
than stay and risk being tainted by association with the
bankrupt firm.
• Suppliers may refuse to deliver trading inventory, and
customers may refuse to buy if they perceive a risk that the
after-sales service will not be there.
• It may be necessary to liquidate non-current assets in order to
finance working capital, thus entailing a reduction in the scale
of operations.
• Parties with which the firm is contracted may renege on
contracts if it is advantageous to them, knowing that the firm is
not in a position to bring lengthy and expensive legal action.
 Self-test 03
According to Modigliani and Miller the cost of
equity will always rise with increased gearing
because
a) the firm is more likely to go bankrupt
b) debt is allowable against tax
c) the return to shareholders becomes more
variable
d) the tax shield on debt increases the value of the
shareholders' equity
 Answer to Self-test 03
• Answer: C
• At very high levels of gearing the firm is more
likely to go bankrupt, but this risk is basically
transferred to debt holders.
• Debt, as a tax allowable expense, results in the
tax shield which increases the value of the
firm, but does not affect the risk of equity.
 Answer to Self-test 04
• Answer: A

• If the company were to automate its

production line, its level of fixed costs would
increase and its variable costs decrease.
• Therefore operating leverage would increase.
 Conflicts between Shareholders and Debt
Holders
There are ways in which managers (appointed by shareholders) can act in the
interests of the shareholders rather than the debt holders and in doing so,
contribute to the indirect costs of bankruptcy, for example:
• Paying large cash dividends to the shareholders at the expense of the debt
holders
• Managers may try to hide the extent of a firm's poor financial state by cutting
back on research, maintenance, etc. and thus improve the results of 'this
year' at the expense of those of 'next year'. This 'playing for time' tactic can
worsen a debtholder's position
• Management may negotiate a loan for a relatively safe investment, and
therefore carrying only modest interest charges, and then use the funds to
finance a far riskier investment
• Management may arrange further loans which increase the risks of the initial
lenders by undercutting their asset backing
 Conflicts between Shareholders and Debt
Holders (cntd)
• It is probably fair to say that most managers do not actively set out to
deceive lenders, as they have little to gain – after all most of them are
employees rather than owners and may suffer considerable personal loss
if their company goes bankrupt (it is often not easy for the financial
director of a failed firm to find similar employment elsewhere).
• In addition, they know that, although these tactics may be to the short-
run gain of the equity holders, they cannot expect to win in the long run –
one may deceive a lender once but it is doubtful if the deception will
work a second time.
• Nevertheless, it is because of the risk that managers might act in this way
that most loan agreements contain restrictive covenants for protection of
the lender. Complying with such covenants places a restriction on the
actions of managers and imposes a potential additional cost of borrowing.
• These restrictions on the managers or agents are referred to as agency
costs.
 Loan Covenants
Covenants used by suppliers of debt finance can be divided into four main
categories:
Restrictions on issuing new debt
These usually prevent the issue of new debt with a superior claim on assets unless
the existing debt is upgraded to have the same priority, or unless the firm
maintains a minimum prescribed asset backing. Restrictions on asset rental and
sale are also often used.
Restrictions on dividends
Dividend growth is usually required to be linked to earnings. Repurchase of equity
(effectively a dividend) is also often restricted.
Restrictions on merger activity
Debt covenants may prohibit mergers unless post-merger asset backing of loans is
maintained at a minimum prescribed level.
Restrictions on investment policy
Covenants employed include restrictions on investments in other companies,
restrictions on the disposal of assets, and requirements for the maintenance of
assets. This is usually considered to be the most difficult aspect for creditors to
monitor.
 Loan Covenants (cntd)

Contravention of these agreements will usually

result in the loan becoming immediately
repayable, thus allowing the debenture holders
to restrict the size of any losses.
Obviously no set of covenants can completely
protect creditors, and any remaining risks will be
covered by the interest rate charged and by
securing loans on the assets of the company.
 Tax Exhaustion
• A further disincentive to high gearing is that the firm must be in a
taxpaying position to obtain the tax shield on debt.
• At a certain level of gearing companies will discover that they have no
taxable income left against which to offset interest charges.
• This is particularly likely if they have been investing heavily and are in
receipt of large tax depreciation. After this point firms will experience all
the problems of gearing but none of the advantages.
• The effect of the risks and costs of bankruptcy, the agency costs and tax
exhaustion is likely to push up both the cost of equity and the cost of debt.
• The conclusion is that there is now an optimal level of gearing, but no easy
way of determining where it is. In other words, the traditional view.
• The next section looks at some of the factors which determine the amount
of gearing a firm should have.
 Practical Aspects in the Capital Structure
Decision
In addition to the above points, the following practical aspects apply
equally to the traditional and M&M theories:
Business risk
Gearing adds financial risk on top of business risk; hence the higher the
business risk (including operating risk), the lower the gearing tends to be
Bankruptcy
Bankruptcy costs (legal, administrative, forced sale of assets at less than
market value) have a higher chance of being incurred the higher the
gearing
Quality of assets
Lenders look for security: thus firms with substantial tangible assets
(land, buildings, plant and equipment) tend to be able to borrow more
 Practical Aspects in the Capital Structure
Decision (cntd)
Availability of other sources of finance
Small firms may have limited access to external finance and
are forced to use equity (e.g. retained earnings) rather than
borrowings
Cost of raising finance
Issue costs are zero for retained earnings, whereas new issues
are much more expensive. Loan finance is cheap to raise
Tax rate
The higher the tax rate the higher the tax relief on interest,
subject to tax exhaustion.
Practical Aspects in the Capital Structure
Decision (cntd)
 Practical Aspects in the Capital Structure
Decision (cntd)
In addition the following should be borne in mind:
Signaling
Raising debt could be taken as a sign of confidence by investors, i.e. the
directors are sufficiently confident about future prospects that they are
willing to expose the business to fixed capital and interest payments
Clientele effect
Particular shareholders (a 'clientele') may be satisfied with the existing
level of gearing of a firm (e.g. in the context of their wider portfolios of
investments). A change in the level may not suit them and they may sell
their shares. Equally the change in gearing may suit new investors who
would want to buy the firm's shares. The net effect may be adverse, i.e.
the wealth of the original shareholders may fall.
 Adjusted Present Value
In a with tax world, M&M argued that changing the
capital structure may cause the cost of capital to
alter.
• Projects financed with new debt can be evaluated
using the Adjusted Present Value (APV) technique.
• APV – Find the base case NPV @ keu
– Adjust for the present value of the tax
shield @ kd
 Changing Capital Structure
Worked Example: Changing Gearing
Spears Ltd is currently an all equity company. It is considering
borrowing a significant amount to finance a new project. The
new project is similar, in terms of business risk, to the existing
projects.
(a) What will happen to the company's cost of capital?
(b) What cost of capital should be used to assess the new
project
(i) The existing cost of capital?
(ii) The cost of the new debt?
(iii) The new WACC?
 Worked Example - Changing Gearing:
Solution
(a) The increased level of gearing may cause the overall WACC to
fall, due to the tax shield on the debt interest.
(b) The company's existing cost of capital (the cost of equity ke) is
inappropriate, as the new gearing will have altered it.
The cost of the new debt is not the correct discount rate,
because the cost of debt does not reflect the risk that will be
borne by the shareholders.
The new WACC is difficult to identify, for the following reason:
 Worked Example - Changing Gearing:
Solution (cntd)
• One component of the above is the market value of the
shares (MVe in the above equation) – which reflects the
impact of both the new debt and the project.
• The impact of the new project on the share value is its NPV –
the value of the shares should reflect the wealth created by
the project.
• The NPV requires the new cost of capital (the new WACC) to
be known.
• Thus there is a problem – to find the new cost of capital
requires the new market value of the shares, this requires the
NPV to be known which in turn requires the new cost of
capital.
 Adjusted Present Value
The Adjusted Present Value (APV) approach can be used to address
the above problem in the following way:
1. Calculate a base case value of a project using keu (cost of equity
for an ungeared company), this gives the value of the project as if
it were ungeared
2. Establish the present value of the tax shield arising as a result of
the debt capacity generated by the project.

Adding these two together gives an Adjusted Present Value (APV)

which should be interpreted in the same way as an NPV. For
example, a positive value for the APV indicates an increase in
shareholder wealth, and so the project should go ahead.
 Interactive Question 3: APV
Toes Ltd, currently all equity financed, is considering a
project which will involve investing CU250 million now and
will generate annual net cash flows of CU40 million for each
of the next 10 years. The project will use buildings and
equipment which, when used as security, will enable Toes
Ltd to borrow CU187.5 million at a rate of 8%. The costs of
issuing the debt are CU1 million. The debt will last as long as
the project: 10nyears.
Corporation tax rate is 30%.
If the project were to be funded entirely by equity, the cost
of capital would be 12%.
Interactive Question 3: APV (cntd)
 Answer to Interactive Question 3

• So, project worthwhile overall (in fact project itself is no good,

but financial benefit creates positive NPV).
Problems with the APV Approach
The technique is based upon the assumptions of
M&M with tax. That means that issues such as
agency costs and financial distress may affect
the attractiveness of debt finance which are not
reflected in this technique.
 Gearing and the CAPM
Revisiting CAPM again briefly, the βe (beta of
equity) is sensitive not only to the amount of
systematic risk but also to the amount of financial
risk, i.e. the level of gearing.
Worked Example: Gearing Betas
• What happens to the required return on a share
if the company takes on more debt?
• What are the implications of this for the beta
value?
Worked Example - Gearing Betas: Solution
• The relationship between the required return on a share and
the level of gearing is as shown in the graph.

The reason the required return goes up is because as a company

borrows more, the risk that the shareholders face will increase.
It follows that a geared company’s shares will have a higher beta.
 Gearing and the CAPM (cntd)
• This is because financial risk applies systematically i.e. it cannot be
diversified away.
• In the CAPM the βe rises as gearing increases. (Debt can also have a beta
such that the required return is greater than the risk free rate. For simplicity
in what follows it is assumed that debt is risk free and its beta is zero.)
• The assets of a business contain only systematic business risk which is
measured by βa (asset beta). In an ungeared firm this must be the same as βe
(there is no financial risk). But, as gearing increases the βe increases, such
that βe > βa. One way of relating βe, βa and the level of gearing (assuming risk
free debt) is

where D and E are the market values of debt and equity respectively, and T is the
corporation tax rate.
 Gearing and the CAPM (cntd)
• One particular use of this relationship is deriving
discount rates for project appraisal which take account
of both the systematic risk of the project and the
financing risk.
• While the CAPM is a less than perfect theory, it is robust
enough to be widely used in the real world and certainly
adequate for the examination. Thus a risk-adjusted
discount rate based on the systematic risk of a project
can be devised and used to derive the project's NPV, in
order to determine whether or not it is acceptable.
 Interactive Question 4: CAPM
• Hubba Ltd, an all equity financed food manufacturer, is about to
embark on a major diversification into the consumer electronics
industry. Its current equity beta is 1.2, while the average equity
beta of electronics firms is 1.6. Gearing in the electronics industry
averages 30% debt, 70% equity by market values. Debt is
considered risk free.
rm = 25% rf = 10% T = 30%
• Requirement
Estimate a suitable discount rate for the project if it were financed
(a) Entirely by equity
(b) By 30% debt, 70% equity (by market values)
(c) By 40% debt, 60% equity (by market values)
Answer to Interactive Question 4
Answer to Interactive Question 4 (cntd)
 Self-test 06

One of the following diagrams in the next slide is consistent

with the so-called 'traditional view' of gearing often held
in contrast with the views of Modigliani and Miller.
Which diagram is correct?
Self-test 06 (cntd)
 Answer to Self-test 06
• Answer: C
• As gearing increases k first falls due to the
lower cost of debt, but as ke begins to increase
rapidly, this dominates and k rises.
 Self-test 07
A tax-paying company is financed in equal proportions by
equity and debt. The interest on debt is tax deductible
at the corporation tax rate of 30%.
What will be the effect of an increase in the rate of
corporation tax on the value of the company?
a) Increases the value of the company
b) Reduces the value of the company
c) No change to the value of the company
d) Increases or decreases the value of the company
dependent upon the extent of the increase
 Answer to Self-test 07
• Answer: B
• If the company is financed (initially) in equal
proportions by debt and equity, an increase in
the tax rate reduces the value of the company.
Thus because there will be less in total to pay
to investors, irrespective of the tax shield on
debt interest.
 Self-test 08
An extract from the balance sheet of Jug Ltd is as follows.
CU
Ordinary shares of CU1 each 3,000,000
Reserves 11,000,000
Total equity 14,000,000
The current market value of the shares is CU8
The company also has in issue CU16 million of debt,
which you can assume to be risk-free, which is
currently valued at par.
The equity beta of Jug is 1.20.
 Self-test 08 (cntd)
The company proposes to issue new shares to raise CU4
million in order to pay off some of its debt.
The tax rate is 25%.
Assuming there are no transaction costs with issuing the
new shares or redeeming CU4 million of debt, what
should the equity beta of the company be after the
capital restructuring?
 Answer to Self-test 08
• The equity beta will be 1.06.
• The market value of the company's equity is CU24
million.
• Step 1 is to convert the current equity beta (β g) into a
beta for an identical all equity-company (βa).
βa = βg × E/(E + D(1 – t))
βa = 1.2 × 24/(24 + 16 (1 – 0.25)) = 0.8
• By raising CU4 million in equity to pay off debt, it has to
be assumed that the company's equity shares will be
worth CU28 million and the debt capital CU12 million.
 Answer to Self-test 08 (cntd)
• At this new gearing level, the equity beta (βg)
will be:
βg = βa/[E/(E + D (1 – t))]
βg = 0.80/[28/(28 + 12 (1 – 0.25))] = 1.057,
say 1.06
 Self-test 09

The beta value of the equity shares of A Ltd is 0.89 and the beta of the equity of D Ltd is
1.22.
Within which range will the beta values of the equity of B Ltd and C Ltd lie?
a) The beta of B Ltd and the beta of C Ltd are both higher than 1.22.
b) The beta of B Ltd is in the range 0.89 to 1.22 and the beta of C Ltd is higher than
1.22.
c) The beta of B Ltd is above 1.22 and the beta of C Ltd is in the range 0.89 to 1.22.
d) The beta of B Ltd is below 0.89 and the beta of C Ltd is in the range 0.89 to 1.22.
 Self-test 10
A company is considering a new project that would earn cash profits before tax of
CU5,000,000 per annum for three years. Tax is at the rate of 30% of cash
profits. The cost of the project would be
CU7,500,000 and the finance would be obtained by obtaining a five year loan at
10% interest, for which annual repayments would be as follows:

Loan issue costs would be CU100,000. The loan would significantly alter the
company's gearing. Its current weighted average cost is 12%, but if the
company were all equity financed, its cost of capital would be 13%.
What is the adjusted present value of the project, to the nearest
CU100,000?
 Self-test 11
SORINA LTD
Sorina Ltd has always been an all equity financed company with a cost of
capital of 15%. The finance director, Mr Brush, has read an article extolling the
benefits of raising debt finance and has asked you to provide him with advice
as to how Sorina Ltd should finance itself for the future. He is also interested
in what discount rate he should be using for project appraisal. In order to
assist you Mr Brush has helpfully collected data on four companies which is
summarised below.
 Self-test 11 (cntd)
For each of these companies the dividends have been constant at
the above levels for many years. Companies P and Q operate in
the same industrial sector, while companies R and S both
operate in a different industrial sector which is perceived as
more risky than that of P and Q.
All four companies and Sorina Ltd itself operate in Widbergia, a
country that is at present a tax-free society.
You also ascertain that debt, which may be assumed to be risk-free,
is currently yielding 6% per annum to investors.

Requirements
(a) Comment on the data supplied by Mr Brush in relation to the optimal
capital structure of Sorina.
Ltd and advise on an appropriate discount rate for project appraisal.
(b) Indicate how your advice might change if corporate taxes were
introduced into Widbergia.
Note. Your answer should address both theories of gearing.
 Self-test 12
SORINA LTD
Sorina Ltd has always been an all equity financed company with a cost of
capital of 15%. The finance director, Mr Brush, has read an article extolling the
benefits of raising debt finance and has asked you to provide him with advice
as to how Sorina Ltd should finance itself for the future. He is also interested
in what discount rate he should be using for project appraisal. In order to
assist you Mr Brush has helpfully collected data on four companies which is
summarised below.
 Self-test 13
SORINA LTD
Sorina Ltd has always been an all equity financed company with a cost of
capital of 15%. The finance director, Mr Brush, has read an article extolling the
benefits of raising debt finance and has asked you to provide him with advice
as to how Sorina Ltd should finance itself for the future. He is also interested
in what discount rate he should be using for project appraisal. In order to
assist you Mr Brush has helpfully collected data on four companies which is
summarised below.