Topic 10: Capital Structure Theory and Project Appraisal Adjustments

10.1
 Contents
1 Capital structure
1.1 Business and financial risk (definitions)
1.2 Gearing (operating versus financial)
1.3 Impact of financial gearing (effect on earnings per share)
1.4 The idea of an optimal capital structure (Traditional view of gearing)
2 The theory of capital structure developed by Modigliani & Miller
2.1 M&M 1958: capital structure ignoring the effect of taxation
2.1.1 Unlevered (all equity) company
2.1.1.1 Return on assets
2.1.1.2 Value of the company (=value of equity)
2.1.1.3 Cost of equity
2.1.1.4 WACC (unlevered)
2.1.2 Levered company
2.1.1.3 Cost of levered equity (using EBT(levered))
2.1.1.4 WACC (levered) (=WACC(unlevered))
2.1.1.2 Value of the levered company (=value of unlevered company)
2.1.3 Why is capital structure irrelevant?
2.1.4 M&M assumptions
2.1.5 The M&M formula for the cost of equity capital (no taxes)
2.1.5.1 Derivation
2.1.5.2 Application
2.2 M&M 1963: capital structure allowing for the effect of taxation
2.2.1 Unlevered (all equity) company
2.2.1.2 Value of the company (lower because of tax)
2.2.1.3 Cost of equity (same as with no tax)
2.2.1.4 WACC (unlevered) (same as with no tax)
2.2.2 Levered company
2.2.2.1 EBT (levered)
2.2.2.2 EAT (levered)
2.2.2.2.1 Derivation of relationship to EAT (unlevered)
2.2.2.2.2 Application of relationship to EAT (unlevered)
2.2.2.3 PV of the tax shield
2.2.2.4 Value of the levered company

10.2
 2.2.2.5 Value of the equity (levered) (value of company – value of debt)
2.2.2.6 Equity cost of capital (using EAT (levered))
2.2.2.7 The M&M formula for the cost of equity capital (with taxes)
2.2.2.7.1 Derivation
2.2.2.7.2 Application
2.2.2.8 The WACC (levered) (with taxes)
2.2.2.9 Value of the levered company using the WACC (as a check only)
3 Problems associated with high levels of gearing
3.2 Bankruptcy costs (direct and indirect)
3.3 Conflicts between shareholders and debt holders (Agency costs)
3.4 Loan covenants
3.5 Tax exhaustion
4 Pecking Order Theory
4.1. The role of asymmetric information
5 Project Appraisal when you need to adjust for Gearing
5.1 Adjusted present value
5.2 Adjusting the WACC
5.2.1 Gearing and the CAPM
5.2.2 Gearing and de-gearing betas
Learning Objectives
Theory
 To understand and explain the problems that can arise as companies take on more debt.
 Show, using a simple numerical example, if and how changing the capital structure affects the cost of
capital, the cost of equity capital and the value of a company.
Practice
 To calculate the implications of the financing of a project on company value using the APV method
 To calculate the WACC when a change in gearing affects the cost of equity capital

10.3
 Introduction and Concepts
Business Risk v Financial Risk
Business risk refers to the variability in the earnings (before interest and taxes) of the company
Financial risk refers to the variability in the returns to shareholders as a result of taking on debt
Note: Financial risk, in a more wide context, may include liquidity risk, interest rate risk, and currency risk.

Operating Gearing (Leverage)

The proportion of fixed costs in total costs.
Higher Operating Gearing increases the variability of earnings
Example
Recession (-10%) Normal Boom (+10%) Recession (-10%) Normal Boom (+10%)
Sales £m 4.5 5 5.5 4.5 5 5.5
VC £m -2.7 -3 -3.3 -0.9 -1 -1.1
FC £m -1 -1 -1 -3 -3 -3
EBIT £m 0.8 1 1.2 0.6 1 1.4

10.4
Financial Gearing (Leverage)
This is the extent to which debt is used in the capital structure
Note: Preference shares are usually treated as debt, due to their fixed payments
Three typical measures:
Equity Gearing
Long term debt + preference share capital
ordinary share capital + reserves
Total (Capital) Gearing
Long term debt + preference share capital
Total long term capital
Interest Gearing
Debt interest
EBIT
Note: Interest Gearing is the inverse of the Interest Cover ratio (= EBIT / Debt Interest)

10.5
Increased debt increases the variability of Earnings per Share
Consider a company that issues £5m of debt to buy back £5m of its shares.
1,000,000 shares at £10 per share 500,000 shares at £10 per share + £5,000,000 debt
Recession (-10%) Normal Boom (+10%) Recession (-10%) Normal Boom (+10%)
Sales £m 4.5 5 5.5 4.5 5 5.5
VC £m -2.7 -3 -3.3 -2.7 -3 -1.1
FC £m -1 -1 -1 -1 -1 -1
EBIT £m 0.8 1 1.2 0.8 1 1.2
Interest (4%) -0.2 -0.2 -0.2
EBT £m 0.8 1 1.2 0.6 0.8 1.0
EPS £ 0.8 1 1.2 1.2 1.6 2.0

The change in the capital structure makes the shares more risky, the variability of EPS increases for any
given change in the level of sales.
For the levered case, note also that the variability in EPS (±25%) > variability in EBT (±20%) > variability in
Sales (±10%).

10.6
The Idea of an Optimal Capital Structure (Traditional Theory)
We have just seen that the risk of equity increases as debt increases, the increased risk of
equity will increase its required return. This increase in the cost of equity capital will increase
the WACC (all other things equal).
We know that the cost of debt is usually less than the cost of equity, so increasing debt will
lower the WACC (all other things equal).
𝑉𝑒 𝑉𝑑
𝑊𝐴𝐶𝐶 = 𝑟𝑒 ↑ ↓ +(1 − 𝑡𝑐 )𝑟𝑑 ↑
𝑉𝑒 + 𝑉𝑑 𝑉𝑒 + 𝑉𝑑
Because these two effects work in opposition, it was thought (until 1958) that there might be
an optimal mix of debt and equity, i.e., a lowest possible WACC.
The idea is that as debt is first introduced, its lower cost of capital reduces the WACC, as there isn’t yet any
significant additional risk to equity to increase its cost of capital. As debt increases, so the equity cost of
capital will increase as equity holders demand compensation for the extra risks they face and this will
eventually dominate leading to an increase in the WACC. But, somewhere in between there is a minimum.
This is a very intuitive idea, but it is false.
In 1958, it was shown that the equity cost of capital increases to exactly offset the benefits
from the lower cost of debt, at all debt levels. Capital structure is irrelevant.

10.7
 Capital Structure Irrelevance (Modigliani and Miller, 1958)
Recall the earlier example (from EBIT onwards) and just using the “Normal” scenario
1,000,000 shares at £10 per share 500,000 shares at £10 per share + £5,000,000 debt
Recession (-10%) Normal Boom (+10%) Recession (-10%) Normal Boom (+10%)
EBIT £m 0.8 1 1.2 0.8 1 1.2
Interest (4%) -0.2 -0.2 -0.2
EBT £m 0.8 1 1.2 0.6 0.8 1.0
EPS £ 0.8 1 1.2 1.2 1.6 2.0
If we assume that the earnings (EBIT) are the same each year in perpetuity, then the value of
the company in its unlevered (all equity) state is (using the PV of perpetual cash flow formula)
𝐸𝐵𝐼𝑇 £1𝑚
𝑉𝑈 = = = £10m = £10 × 1m = Share price × No. of shares
𝑟𝑎 𝑟𝑎
from which we can find the required return on the assets (which are generating equity the
earnings, whose discounted value is the value of the company). The required return on the
assets reflects the risk in the cash flows that the assets are generating. Here,
𝐸𝐵𝐼𝑇 £1m
𝑟𝑎 = = = 0.1 = 10%
𝑉𝑈 £10m

10.8
As the company is all-equity financed, then the company value must equal the share value,
𝑉𝑒𝑈 = 𝑉𝑢 = £10m
and the required return on equity, 𝑟𝑒𝑈 , is the same as the required return on the assets, that is,
𝑟𝑒𝑈 = 𝑟𝑎 = 10%
And as there is no debt, this is also the WACC for the firm, in its unlevered state, that is
𝑊𝐴𝐶𝐶𝑈 = 𝑟𝑒𝑈 = 𝑟𝑎 = 10%
In class example:
An all-equity company has 1 million shares and earnings before tax (EBIT) of £400,000. If its
required return on assets is 16%, find the value of the company, the share price, the equity
cost of capital and the WACC.

10.9
The effect of Leverage on the equity cost of capital and the WACC
We assumed in the example that the debt cost of capital is 4%, but what about the equity cost
of capital? Again, assume that the earnings to equity continue in perpetuity and so can be
valued as
𝐸𝐵𝑇𝐿 £0.8m
𝑉𝑒𝐿 = = = £10 × 0.5m
𝑟𝑒𝐿 𝑟𝑒𝐿
From this, we can find 𝑟𝑒𝐿 ,
𝐸𝐵𝑇𝐿 £0.8m
𝑟𝑒𝐿 = = = 0.16 = 16%
𝑉𝑒𝐿 £5m
So, the WACC (ignoring taxes) is
𝑉𝑒𝐿 𝑉𝑑
𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 + 𝑟𝑑
𝑉𝑒𝐿 + 𝑉𝑑 𝑉𝑒𝐿 + 𝑉𝑑
£5m £5m
𝑊𝐴𝐶𝐶𝐿 = 0.16 × + 0.04 × = 0.10 = 10%
£5m + £5m £5m + £5m
So, the WACC does not change when the capital structure does, nor does the company value
𝐸𝐵𝐼𝑇 £1m
𝑉𝐿 = = = £10m = 𝑉𝑈
𝑊𝐴𝐶𝐶𝐿 0.10
10.10
Why is capital structure irrelevant?
Simply, because nothing has changed on the asset side of the balance sheet and so the
company value and its cost of capital stays the same.
But, why does increased debt not affect value? Answer: (M&M’s contribution) because
shareholders in an all-equity firm could take on equivalent personal debt, to create an identical
situation to if the company had taken on the debt.
1,000,000 shares at £10 per share + 500,000 shares at £10 per share +
Personal debt of £5,000,000 £5,000,000 corporate debt
(-10%) Normal (+10%) (-10%) Normal (+10%)
EBIT £m 0.8 1 1.2 0.8 1 1.2
Interest (4%) -0.2 -0.2 -0.2
EBT £m 0.8 1 1.2 0.6 0.8 1.0
Less interest on -0.2 -0.2 -0.2
personal debt (4%)
Effective EBT £ 0.6 0.8 1.0 0.6 0.8 1.0

As earnings are the same, then the cost of equity, and so the value of equity remains the same,
whether the debt is corporate or personal.

10.11
M & M Assumptions
What assumptions does the equivalence of personal and corporate debt (which implies the
irrelevance of capital structure) rely on?
 No taxes
 Perfect information that is processed and acted upon instantaneously and rationally
 No transactions costs
 The cost of debt is fixed, and the same for all debt types
 There is no risk of the debt defaulting
 Earnings streams are perpetual

10.12
The equity cost of capital (with no taxes)
In the no tax world, the WACC, does not depend on leverage, and so we can treat it as a
constant, and because of this we can invert it to get an equation for the cost of equity capital
𝑉𝑒𝐿 𝑉𝑑
𝑟𝑎 = 𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 + 𝑟𝑑
𝑉𝑒𝐿 + 𝑉𝑑 𝑉𝑒𝐿 + 𝑉𝑑
Rearranges to
𝑉𝑑
𝑟𝑒𝐿 = 𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 )
𝑉𝑒𝐿
which we can confirm for our example (𝑟𝑎 = 0.1, 𝑟𝑑 = 0.04, 𝑉𝑑 = £0.5m, 𝑉𝑒𝐿 = £0.5m)
£0.5m
𝑟𝑒𝐿 = 0.1 + (0.1 − 0.04) = 0.16
£0.5m
and which we found earlier using 𝐸𝐵𝑇𝐿 and 𝑉𝑒𝐿 .

Note that the equation for the WACC uses total gearing, whereas the equation for the cost of
equity capital uses equity gearing. This distinction is rarely clarified in textbook diagrams
(including the ICAEW training manual!).
10.13
The equity cost of capital is only a straight line function of gearing if gearing is equity gearing.
The Cost of Capital Diagrams (no tax)
Using Total Gearing Using Equity Gearing

This is the intuitive version that is never in the This is the version that is in all the textbooks, as it is
textbooks! easier to remember, but it is deceptive (the dots
are the same dots in both diagrams)! No textbook
ever puts the horizontal scale on the diagram!

10.14
 Capital Structure Relevancy (M&M with taxes, 1963)
Recall the earlier example (from EBIT onwards) and just using the “Normal” scenario
1,000,000 shares at £8.3 per share 500,000 shares at £8.3 per share + £4,150,000 debt
Recession (-10%) Normal Boom (+10%) Recession (-10%) Normal Boom (+10%)
EBIT £m 0.8 1 1.2 0.8 1 1.2
Interest (4%) -0.166
EBT £m 0.8 1 1.2 0.834
Tax (17%) -0.17 -0.14178
EAT (NOPAT) 0.83 0.69222
The first things to note is that with taxes (but still without debt), the value of earnings is less
than it was without taxes, and so the (all-equity) value of the company will now be lower.
𝐸𝐵𝐼𝑇 (1 − 𝑡𝑐 ) 𝐸𝐵𝑇𝑈 (1 − 𝑡𝑐 ) 𝐸𝐴𝑇𝑈 £0.83m
𝑉𝑈 = = = = = £8.3m
𝑟𝑎 𝑟𝑎 𝑟𝑎 0.1
And as there’s no debt (so far), 𝑉𝑒𝑈 = 𝑉𝑈 = £8.3m, and 𝑊𝐴𝐶𝐶𝑈 = 𝑟𝑒𝑈 = 0.10 = 10%.
So, if the company now wants to swap half of its equity for debt, it now only needs to swap
£4.15m of equity for £4.15m of debt. As a result, the interest payment on the debt is now
𝑟𝑑 × 𝑉𝑑 = 0.04 × £4.15m = £166,000

10.15
Earnings before tax, which are EBIT after the deduction of interest, are
𝐸𝐵𝑇𝐿 = 𝐸𝐵𝐼𝑇 − 𝑟𝑑 𝑉𝑑 = £1.0m − £0.166m = £834,000
The company pays tax on these earnings (with interest deducted), which at 17% is
= 0.17 × £834,000 = £141,780
and so the after tax (and interest) earnings to the shareholders are
𝐸𝐴𝑇𝐿 = 𝐸𝐵𝑇𝐿 (1 − 𝑡𝑐 ) = 𝐸𝐵𝑇𝐿 − 𝑡𝑐 𝐸𝐵𝑇𝐿 = £834,000 − £141,780 = £692,220
Now suppose that the shareholders who issued debt to buy back shares, issued the debt to
themselves. That is, they just used £4.15m of their shares to buy the £4.15m debt. In that case,
they are also getting the interest income on the debt, which is (at 4%), £0.166m. So, the total
shareholder earnings has increased to
𝐸𝐴𝑇𝐿 + 𝑟𝑑 𝑉𝑑 = £692,220 + £166,000 = £858,220
By switching debt for equity they have raised their earnings from £830,000 to £858,220.
So, how is 𝐸𝐴𝑇𝐿 related to 𝐸𝐴𝑇𝑈 ? [CFA Level III]

10.16
The relation between Earnings After Tax
We start by expanding out the definition of earnings after tax for a levered company, including
the debt interest (also assumed to be owned by the company)
𝐸𝐴𝑇𝐿 + 𝑟𝑑 𝑉𝑑 = (𝐸𝐵𝐼𝑇 − 𝑟𝑑 𝑉𝑑 )(1 − 𝑡𝑐 ) + 𝑟𝑑 𝑉𝑑
= 𝐸𝐵𝐼𝑇(1 − 𝑡𝑐 ) − 𝑟𝑑 𝑉𝑑 (1 − 𝑡𝑐 ) + 𝑟𝑑 𝑉𝑑
= 𝐸𝐵𝐼𝑇 (1 − 𝑡𝑐 ) + 𝑡𝑐 𝑟𝑑 𝑉𝑑
= 𝐸𝐵𝑇𝑈 (1 − 𝑡𝑐 ) + 𝑡𝑐 𝑟𝑑 𝑉𝑑
= 𝐸𝐴𝑇𝑈 + 𝑡𝑐 𝑟𝑑 𝑉𝑑
= £1m(1 − 0.17) + 0.17 × £0.166m
= £830,000 + £28,200
= £858,200
from which we can also see that
𝐸𝐴𝑇𝐿 + 𝑟𝑑 𝑉𝑑 = 𝐸𝐴𝑇𝑈 + 𝑡𝑐 𝑟𝑑 𝑉𝑑
implies
𝐸𝐴𝑇𝐿 = 𝐸𝐴𝑇𝑈 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
We are now going to see three applications of these last two equations:
 Valuing a Levered Company (by (i) adding in the PV of the tax shield, or (ii) using the WACCL)
 Developing the equation for the equity cost of capital for a levered firm (first proved by M&M, 1963)
10.17
The Value of a Levered Company: Adding in the Present value of the Tax Shield
In the above example, issuing debt has raised the earnings of the company by 𝑡𝑐 𝑟𝑑 𝑉𝑑 = £28,200.
Recall, the total earnings could be represented as
= 𝐸𝐴𝑇𝑈 + 𝑡𝑐 𝑟𝑑 𝑉𝑑
= £830,000 + £28,200
= £858,200
This extra value arises because the use of debt has allowed the shareholders to reduce the tax
payment. So, what is this worth to the company? How much does company value increase?
Let’s suppose that these extra earnings continue in perpetuity, then the value of them is
𝑡𝑐 𝑟𝑑 𝑉𝑑 £28,200
PV tax shield = = = £705,500
𝑟𝑑 0.04
We use the debt cost of capital to value these cash flows as they arise from the use of debt.
The company value increases to
𝑉𝐿 = 𝑉𝑈 + PV tax shield = £8,300,000 + £705,500 = £9,005,500

10.18
Note also that
𝑡𝑐 𝑟𝑑 𝑉𝑑
= 𝑡𝑐 𝑉𝑑 = 0.17 × £4,150,000 = £705,500
𝑟𝑑
and so the PV of the tax shield can be more quickly calculated as 𝑡𝑐 𝑉𝑑 .

10.19
The value of equity and the cost of equity in a levered company with tax
We have just seen that the tax deductibility of interest raises the value of a levered company
𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐 𝑉𝑑
We also know that the value of a company is equal to the value of its equity plus the value of
its debt, and so the value of equity in a levered company (with tax) is
𝑉𝑒𝐿 = 𝑉𝐿 − 𝑉𝑑
in our example, this is
= £9,005,500 − £4,150,000 = £4,855,500
and, assuming that equity earnings are perpetual, then we can find the cost of equity capital as
𝐸𝐴𝑇𝐿 (𝐸𝐵𝐼𝑇 − 𝑟𝑑 𝑉𝑑 )(1 − 𝑡𝑐 ) £692,220
𝑟𝑒𝐿 = = = = 0.1426 = 14.26%
𝑉𝑒𝐿 𝑉𝑒𝐿 £4,855,500

10.20
Equity Cost of Capital (M&M with tax)
From
𝐸𝐴𝑇𝐿
𝑟𝑒𝐿 =
𝑉𝑒𝐿
which we have just used, we substitute the relation between 𝐸𝐴𝑇𝐿 and 𝐸𝐴𝑇𝑈 derived earlier,
𝐸𝐴𝑇𝐿 = 𝐸𝐴𝑇𝑈 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
and multiple through by 𝑉𝑒𝐿 to get
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝐸𝐴𝑇𝑈 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
Recall that
𝐸𝐴𝑇𝑈 𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐 𝑉𝑑 𝑉𝑒𝐿 = 𝑉𝐿 − 𝑉𝑑
𝑉𝑢 =
𝑟𝑎
which we substitute in turn as follows
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 𝑉𝑈 − (1 − 𝑡𝑐 )𝑟𝑑 𝑉𝑑
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 (𝑉𝐿 − 𝑡𝑐 𝑉𝑑 ) − (1 − 𝑡𝑐 )𝑟𝑑 𝑉𝑑
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 (𝑉𝑒𝐿 + 𝑉𝑑 − 𝑡𝑐 𝑉𝑑 ) − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑

10.21
Now, we just rearrange this
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 (𝑉𝑒𝐿 + 𝑉𝑑 − 𝑡𝑐 𝑉𝑑 ) − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
as follows
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 (𝑉𝑒𝐿 + (1 − 𝑡𝑐 )𝑉𝑑 ) − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 𝑉𝑒𝐿 + 𝑟𝑎 (1 − 𝑡𝑐 )𝑉𝑑 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
𝑟𝑒𝐿 𝑉𝑒𝐿 = 𝑟𝑎 𝑉𝑒𝐿 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 ) 𝑉𝑑
𝑟𝑒𝐿 𝑉𝑒𝐿 𝑟𝑎 𝑉𝑒𝐿 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 ) 𝑉𝑑
=
𝑉𝑒𝐿 𝑉𝑒𝐿
𝑉𝑑
𝑟𝑒𝐿 = 𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 )
𝑉𝑒𝐿
This is a key result provided by M&M 1963 that the equity cost of capital (with tax) can also be
obtained by a formula similar to the no tax case, that is
𝑉𝑑
𝑟𝑒𝐿 = 𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 )
𝑉𝑒𝐿
and we can verify this for our example
£4,150,000
𝑟𝑒𝐿 = 0.1 + (0.1 − 0.04)(1 − 0.17) = 0.1426 = 14.26%
£4,855,500
10.22
The WACC (in the M&M 1963 world with tax)
From the equity cost of capital, in either form,
𝐸𝐴𝑇𝐿 𝑉𝑑
𝑟𝑒𝐿 = 𝑟𝑒𝐿 = 𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 )
𝑉𝑒𝐿 𝑉𝑒𝐿

we can re-compute the WACC (where we now also use the after-tax cost of debt)
𝑉𝑒𝐿 𝑉𝑑
𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 + (1 − 𝑡𝑐 )𝑟𝑑
𝑉𝑒𝐿 + 𝑉𝑑 𝑉𝑒𝐿 + 𝑉𝑑
£4,855,500 £4,150,000
= 0.1426 × ( )
+ 1 − 0.17 × 0.04 × = 0.0922 = 9.22%
£9,005,500 £9,005,500

Notice that as well as the company value increasing, the WACC has also decreased, from 10%
in the unlevered case, to 9.22% in the levered case. This only happens when (and because)
debt is tax deductible.
Now, let’s look at the diagrams again, to see how WACC and the 𝑟𝐸𝐿 depend on gearing.

10.23

This is not in the textbooks!
Note that the WACC is linear decreasing in total gearing.
The benefits of debt increase at a constant rate.
10.24
Again this is the one in the textbooks.
Note that the cost of equity is again linear increasing in
equity gearing.
Note that the WACC appears to be convex decreasing in
equity gearing, but this is an illusion due to the uneven
spacing of the dots! The benefits of additional debt are still
constant as the amount of debt increases. The ICAEW
training manual perpetuates the illusion.
The ACCA draw this curve as a straight line in their training
manuals, as does the Atrill textbook. This is incorrect.
Calculating the Levered Company Value using the WACC
Starting from the equation for the 𝑊𝐴𝐶𝐶𝐿 ,
𝑉𝑒𝐿 𝑉𝑑
𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 + (1 − 𝑡𝑐 )𝑟𝑑
𝑉𝑒𝐿 + 𝑉𝑑 𝑉𝑒𝐿 + 𝑉𝑑
Multiply through by 𝑉𝐿 (remember that is is by definition, 𝑉𝑒𝐿 + 𝑉𝑑 )
𝑉𝐿 × 𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 𝑉𝑒𝐿 + (1 − 𝑡𝑐 )𝑟𝑑 𝑉𝑑
Now recall that
𝐸𝐴𝑇𝐿 𝐸𝐴𝑇𝐿 = 𝐸𝐴𝑇𝑈 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑
𝑟𝑒𝐿 =
𝑉𝑒𝐿
and make these two substitutions
𝑉𝐿 × 𝑊𝐴𝐶𝐶𝐿 = 𝐸𝐴𝑇𝐿 + (1 − 𝑡𝑐 )𝑟𝑑 𝑉𝑑
𝑉𝐿 × 𝑊𝐴𝐶𝐶𝐿 = 𝐸𝐴𝑇𝑈 − (1 − 𝑡𝑐 ) 𝑟𝑑 𝑉𝑑 + (1 − 𝑡𝑐 )𝑟𝑑 𝑉𝑑
where upon we get the amazing result that
𝑉𝐿 × 𝑊𝐴𝐶𝐶𝐿 = 𝐸𝐴𝑇𝑈
or, rearranging this,
𝐸𝐴𝑇𝑈
𝑉𝐿 =
𝑊𝐴𝐶𝐶𝐿

10.25
The above result gives us now two very simply ways to value a company, either with or without
debt,
All Equity Levered
𝐸𝐴𝑇𝑈 𝐸𝐴𝑇𝑈
𝑉𝑈 = 𝑉𝐿 =
𝑊𝐴𝐶𝐶𝑈 𝑊𝐴𝐶𝐶𝐿

This shows us that to value a firm, you can use a cash flow that is independent of the firm’s
leverage, the leverage adjustment is done through the WACC.
It also shows us why estimating the WACC is so important in practice.
When the cash flow above is more generally defined (to also include change in working capital,
capital investment and to adjust for depreciation), it is called the Free Cash Flow to the Firm,
FCFF.
We will see this in topic 11, and how it is used for company valuation in more practical settings.
However, note that in the M&M theoretical setting, the value of the levered company, 𝑉𝐿 ,
depends on the 𝑊𝐴𝐶𝐶𝐿 , which depends on 𝑉𝐿 , and so this is circular. In the M&M setting, 𝑉𝐿 ,
must be found using𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐 𝑉𝐷 , and the above formula serves only as a useful check.

10.26
In class example:
The Western Mat (WM) Company earnings of £125,000, assumed to continue in perpetuity.
The required return on its assets is 12.5%. Its earnings are taxed at 17%. The shareholders have
learned that by restructuring their capital, they can increase their firm’s value. So, they are
considering issuing £400,000 of debt (paying an interest rate of 10%) to buyback some of its
shares. It currently has 100,000 shares.
a) What are the current value of the company and the shares of WM?
b) What are the current equity cost of capital and WACC of WM?
c) What is the tax shield available to WM?
d) What would be the value of the company and the value of the shares after the debt issue?
e) What would be the equity cost of capital and the WACC of WM after the debt issue?

10.27
 The Problems of High Gearing
The implication from the M&M (1963, with tax) analysis is that firms maximise their value by
maximising their debt levels. But, typically firms settle at more modest levels, 30% is very
common, and industries and similar sized firms have similar debt levels.
This is because increasing debt levels
 Increase the chance of insolvency.
 May be restricted by articles of association
 Existing debt may have covenants restricting new debt issuance
Note: As gearing adds financial risk on top of operating (/business) risk, firms with high
business risk tend to have lower gearing.
Direct costs of bankruptcy
If a firm is liquidated, the value of assets sold under distressed conditions is often lower than
their going concern or economic value. Debtholders will require an additional premium to
compensate for this, which will offset some of the tax benefits.
There will also be the legal, administrative and accounting costs of dealing with bankruptcy.

10.28
Indirect costs of bankruptcy (costs of financial distress)
These are the additional costs that a company faces when it is in financial distress.
These tend to increase the equity cost of capital.
Note, at any given time, the equity cost of capital will build in the likelihood of bankruptcy, so
the more likely this is the higher the bankruptcy premium inside the equity cost of capital.
Agency costs
Managers may be tempted to pay a large dividend to appropriate funds from bondholders to
shareholders
Managers may seek to disguise the firms true financial position
Managers may be tempted to misrepresent (artificially lower) the risks of projects for which
new debt finance is being used
Managers may be tempted to take on new loans to pay off other debts
Although the management may not act in this way, the fact that they could, increases the costs
of capital as debt capital will contain covenants to prevent this activity by managers.

10.29
Debt covenants
To mitigate agency costs, debtholders will require covenants on debt such as
 Restrictions on new debt issuance (seniority of claims, asset backing)
 Restrictions on dividend payments (linking them to earnings growth)
 Restricting equity repurchases (as these are like a dividend, see next Topic)
 Preventing of mergers (unless pre-merger loans will be fully asset backed post-merger)
 Restrictions of investment policy (purchase of companies, disposal and maintenance of
assets)
Contravention of covenants usually requires immediate debt repayment.

Tax exhaustion
Offsetting debt interest against tax requires sufficient earnings to be able to deduct them. If a
company is in receipt of large capital allowances, from large investments in capital equipment,
these may already have used up all the potential tax allowances. In that case, increased gearing
will have no benefits, only costs (of possible financial distress and bankruptcy).

10.30
 Pecking Order Theory
This asserts that firms should access finance in the following order
 Retained earnings
 Debt
 Equity
with consideration also given to the relative merits of alternative methods of issuing new
equity (rights issue or public offer), and that small firms may have more restricted choices.
As mentioned in Topic 7, firms have recently been hoarding cash, contrary to this theory.
There are two reasons for this sequential financing choice recommendation:
 Issuance costs
In Topic 7, we discussed this and noted that retained earnings are cheapest, then
debt and then equity. This is both in terms of the required returns and also the
issuance costs.
 Asymmetric information
We mentioned this in Topic 7. It is the idea that issuing equity may convey bad news.
We will now explore this idea in more detail.

10.31
Asymmetric information and financing choices
At the heart of this consideration is that managers typically have better quality information
about a company than either existing or new shareholders.
Myers (1978) view
Managers are likely to prefer to use retained earnings to finance a new project, where they
think that new equity would be issued on terms that under-estimate the quality of the project.
New issues tend to be under-priced (to overcome the adverse selection problem of differently
informed new investors – we saw this in Topic 7) and under-pricing can lead to a transfer of
wealth from existing to new shareholders (we saw this in Topic 7), which might not be popular
with them. For both reasons, managers will prefer retained earnings over new equity. New
debt issuance would also face this consideration but, as it is cheaper than equity, would be
next in line after retained earnings had been exhausted.
Given managers have an incentive to avoid issuing equity even when they have favourable
private information, a new issue of equity may be viewed as a signal of unfavourable private
information. This leads to new equity issues often being seen as bad news. This can create a
vicious cycle with the under-pricing incentive; the bad news signal leads to even greater under-
pricing. So, to avoid conveying bad news, managers prefer to use retained earnings or debt.

10.32
Myers and Majluf (1984) view
The potential under-pricing of new equity would lead firms to prefer to issue equity when the
share price is at its highest. But this could signal to new shareholders that the share prices are
over-valued and that the company actually knows some bad news. Again, managers would
want to avoid signalling bad news by issuing shares.

Empirical Evidence
Asquith and Mullins (1983) found evidence that share prices decline on the announcement of
new issues, confirming the predictions of the asymmetric information mechanism.

10.33
 Gearing and Project Appraisal
Suppose a company is issuing debt to undertake a new project (with the same risks as the
company as a whole), but the change to financing is permanent. This is a circumstance
identified (in Topic 9) as not being able to use the WACC as the discount rate.

The WACC needs to be adjusted for the new level of gearing. This means changing the values of
debt and equity in the calculation.
𝑉𝑒𝐿 𝑉𝑑
𝑊𝐴𝐶𝐶𝐿 = 𝑟𝑒𝐿 + (1 − 𝑡𝑐 )𝑟𝑑
𝑉𝑒𝐿 + 𝑉𝑑 𝑉𝑒𝐿 + 𝑉𝑑
The value of equity will reflect the value of the firm minus the new level of debt.
𝑉𝑒𝐿 = 𝑉𝐿 − 𝑉𝑑
But the firm value will now include the NPV of the new project. This NPV depends on the
WACC, and so this is circular!
The equity cost of capital calculation is also circular, as it depends on the value of equity, which
depends on the value of the firm, which depends on the NPV of the project, which depends on
the WACC, which depends on the equity cost of capital!
10.34
 Adjusted Present Value
The solution to the circularity is to use a method called Adjusted Present Value. This computes
the present value of the project using the existing WACC and then adds the PV of the debt
financing (less any issuance costs).
In class example:
Cockpit Enterprises is currently all-equity financed. It is considering borrowing £187.5m for 10
years at a rate of 8% to part finance a new project. The new project will generate £40m per
year for 10 years, and will cost £240m. The costs of issuing the debt will be £1m. The corporate
tax rate is 17%. If the project were entirely funded by equity, the cost of capital would be 12%
Should the project be undertaken?

10.35
 Estimating the WACC (by Gearing and De-Gearing Beta)
The APV method provides a means to estimate the NPV of a project when gearing changes. To
estimate the WACC (by other than iterating the circularity) requires a different approach.
This method assumes that the CAPM can be applied to estimate all the components of the cost
of capital: assets (i.e., the whole firm), the debt and the equity, that is
𝑟𝑎 = 𝑟𝑓 + (𝑟𝑚 − 𝑟𝑓 )𝛽𝑎 𝑟𝑑 = 𝑟𝑓 + (𝑟𝑚 − 𝑟𝑓 )𝛽𝑑 𝑟𝑒𝐿 = 𝑟𝑓 + (𝑟𝑚 − 𝑟𝑓 )𝛽𝑒𝐿

It then substitutes these three into the M&M formula for the (levered) equity cost of capital:
𝑉𝑑
𝑟𝑒𝐿 = 𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 )(1 − 𝑡𝑐 )
𝑉𝑒𝐿
After a page of algebra, you get (the geared equity beta)
(1 − 𝑡𝑐 )𝑉𝑑 𝑉𝑑
𝛽𝑒𝐿 = 𝛽𝑎 (1 + ) + 𝛽𝑑 (1 − 𝑡𝑐 )
𝑉𝑒𝐿 𝑉𝑒𝐿
which can be inverted to get (the ungeared firm beta)
𝑉𝑒𝐿 𝑉𝑑
𝛽𝑎 = 𝛽𝑒𝐿 + 𝛽𝑑
𝑉𝑒𝐿 + (1 − 𝑡𝑐 )𝑉𝑑 𝑉𝑒𝐿 + (1 − 𝑡𝑐 )𝑉𝑑
Both the ACCA and ICAEW allow you to assume that 𝛽𝑑 = 0 and so you can ignore the light blue bits, and
so we will assume the same. But remember that 𝛽𝑑 = 0 means that 𝑟𝑑 = 𝑟𝑓 , and NOT that 𝑟𝑑 = 0.
10.36
In class example:
Gubbatoni plc, an all-equity food manufacturer, is about to embark on a major diversification
into the consumer electronics industry. Its current equity beta is 1.15. The average equity beta
in the electronics industry is 1.6. Gearing in the electronics industry averages 30% debt and
70% equity. Assume that corporate debt earns the risk-free rate of 10%, that the expected
return on the market portfolio is 25% and that the corporate tax rate is 17%. Estimate the
equity cost of capital and the WACC for Gubbatoni if
a) It finances its expansion using only equity
b) It finances its expansion using 30% debt (and 70% equity)
c) It finances its expansion using 40% debt (and 60% equity)

10.37