Cost of Capital Written Question (15m)

Question 1

What is Gearing?

Answer 1

(Financial Risk)

Measures the proportion of a company’s financing that comes from debt as opposed to equity

Question 2

How does level of gearing effect cost of capital?

Answer 2

If finance is raised entirely from equity, the level of gearing in a company will increase

Increased gearing increases the level of risk for the shareholders = increased cost of equity

Question 3

What is the Traditional Theory of Gearing?

Answer 3

Based on the idea that:

• equity borrowing is more expensive than debt borrowing
• higher levels of gearing increase risk to shareholders = higher cost of equity

If level of gearing changes, so will the Weighted Average Cost of Capital (WACC)

Question 4

What are the implications of the traditional theory of gearing?

Answer 4

• Company should always wish to borrow in the cheapest way possible = raise through debt until it achieves optimal level of gearing
• Once optimal level of gearing is reached, maintain by raising finance through part equity, part debt
• Only illustrates the importance of gearing, does not attempt to quantify the effect

Question 5

Modigliani and Miller Theory of Gearing (ignoring taxes)

Answer 5

Quantified the effect that higher gearing would have on cost of equity

• Produced a formula that would give cost of equity for any level of gearing
• WACC would remain constant for all levels of gearing

Question 6

Implications of ignoring tax

Answer 6

• Irrelevant how a company raises finances, as the overall cost of borrowing is unaffected
• Total Market Value (MV) of company with be unaffected by changes in gearing
• Limited practical relevance as all taxes are ignored
  = development of theory including corporation tax

Question 7

Modigliani and Miller Theory of Gearing (including Corporation Tax)

Answer 7

• Corporation tax reduces the cost of debt to a company (tax relief)
• NO effect on cost of equity as dividends are not tax allowable

Higher levels of gearing = lower WACC

Question 8

Implication of including Corporation Tax

Answer 8

• WACC will fall with higher levels of gearing
• Company’s should raise as much debt as possible (to get as much tax relief as possible
• As level of gearing increases, total MV of company increases
  (More debt borrowing = more interest paid = pay less tax on same profits)

Question 9

Main Assumptions from Modigliani and Miller

Answer 9

• Shareholders have perfect knowledge
• Shareholders act rationally with regard to risk
• A perfect market exists
• Debt interest is tax allowable
• Investors are indifferent with corporate and personal gearing
• Debt borrowing is irredeemable

Question 10

Pecking Order Theory

Answer 10

• Alternative to Traditional Theory
• Firms prefer Retained Earnings to any other source of finance
• Order of Preference:
  1. Retained Earnings
  2. Straight Debt
  3. Convertible Debt
  4. Preference Shares
  5. Equity Shares