BMF - 503 - Chapter4

Chapter 4
CAPITAL STRUCTURE
CHAPTER - 4 Capital structure (127)
Chapter learning objectives
In this chapter you will learn:
 Capital structure decision

 Effect of capital structure on ratios
 Theories of capital structure
 Project specific cost of capital
1 Overview of Chapter
2 Changing Capital Structure
When a business changes its capital structure, there will be an impact on ratio
analysis (especially the gearing ratio) and an impact on the business's WACC.
The impact of a change in capital structure on ratio analysis the gearing ratio
Two key measures of gearing:

Capital gearing = x 100
OR
x 100
Note: Both of these measures are used in practice, but the first one is more commonly
used.
Clearly if a business changes its capital structure by raising new finance as either debt
or equity, these gearing ratios will change.
Exam questions may test the calculation of gearing ratios before and after a change in
capital structure.
Illustration 1 - Gearing ratio calculation
PPP is considering raising Rs 250 million new finance to fund the acquisition of
QQQ. QQQ is considered to have a value to PPP of Rs 270 million.
Extracts from PPP's statement of financial position show:
Rs m
Long term borrowings 950
Share capital (Rs 10 shares) 500
Retained reserves 400
The directors of PPP haven't yet decided whether debt or equity finance should be
used to fund the takeover. However, if equity is to be used, the new shares will be
issued at a price of Rs 26 per share. The current market share price is Rs 29 per
share.
Required:
Calculate the gearing ratio measured as (debt/(debt + equity)):
(a) before the acquisition of QQQ,

(b) after the acquisition, assuming that debt finance is used to fund the takeover,
(c) after the acquisition, assuming that equity finance is used to fund the takeover.
In all cases, present your calculations using both book values and market values.
Solution: Gearing based on book values
Pre acquisition 950 / [950 + (500 + 400)] = 51.4%

Post acquisition using debt (950+250) / [(950+250)+(500+400+20 (W1))] = 56.6%
Post acquisition using equity 950 / [950 + (500 + 400 + 250 + 20 (W1) )] = 44.8%
(W1) Since QQQ is worth Rs 270m to PPP but the purchase price is Rs 250m, the
value of PPP's equity will increase by Rs 20m irrespective of how the purchase is
financed.
Gearing based on market values (W2)
Pre acquisition 950 / [950 + 1,450] = 39.6%

Post acquisition using debt (950+250) / [(950+250) + (1,450+20)] = 44.9%
Post acquisition using equity 950 / [950 + (1,450 + 250 + 20)] = 35.6%
(W2) Market value of existing shares = Rs 29 × 50m = Rs 1,450m
Note: The issue price of the new shares (Rs 26) is irrelevant when calculating the
gearing ratios. Of course the issue price does affect the number of shares issued and
therefore other ratios such as EPS (see further examples below), but gearing ratios are
calculated based on total values of equity and debt so the issue price is not relevant
here.
Impact on other ratios
A change of capital structure may also impact other ratios (such as earnings per share,
earnings yield an interest cover) if the change in financing is associated with a new
project which increases profits.
Illustration 2
Seed Co is considering investment of Rs 20m which is expected to have an NPV of Rs

8m, and is expected to increase profit before interest and tax by Rs 4m per annum.
Extract from the most recent financial statements of Seed Co:
Statement of financial position extracts Rs m

Share capital (Rs 1 shares) 16
Reserves 48
Long term borrowings 56
Income statement extracts Rs m

Profit before interest and tax 15.0
Interest (4.0)
Profit before tax 11.0

Tax at 30% (3.3)
Profit after tax (earnings) 7.7
The current share price of Seed Co is Rs 2.70 per share.

The directors of Seed Co are considering two alternative ways of financing the new
investment.

 Borrow
the Rs 20m at an interest rate 6% per annum,
 Raise the
funds using a 1 for 2 rights issue at Rs 2.50 per share.
Required:
(a) Prepare profit forecasts for Seed Co for next year under both financing options,
assuming that the new project goes ahead. Use the forecasts to calculate the
impact of the project and each financing option on Seed Co’s interest cover,
earnings per share and earnings yield ratios.
(b) Based on the results of your calculations, discuss the likely reaction of the
shareholders and the lenders to each of the possible financing options.
Solution:
(a) Pre project ratios:
Interest cover = Rs 15m/Rs 4m = 3.75 times
Earnings per share (EPS) = Rs 7.7m / 16m = 48.1 cents per share
Earnings yield = EPS / Share price = Rs 0.481 / Rs 2.70 = 0.178, or 17.8%
Income statement Rs m – debt used Rs m – rights issue

forecasts
Profit before interest 19.0 19.0
and tax (Rs 15m + Rs 4m)
Interest (W1) (5.2) (4.2)
Profit before tax 13.8 15.0
Tax at 30% (4.1) (4.5)
Profit after tax (earnings) 9.7 10.5
(W1) Interest on the new debt is 6% of Rs 20m i.e. Rs 1.2m. Assume that interest on
the existing borrowings stays constant.
Share price workings:

Rights issue
If the rights issue goes ahead, the value of the shares after the rights issue will be the
theoretical ex-rights price (TERP), which was introduced in Chapter 4.
TERP = [(N x cum rights price) + issue price] / (N+1)
=[(2 x 2.70) + 2.50]/3 = Rs 2.63
However, since the rights issue will be used to fund the new project with an NPV of Rs
8m, the value of the project will also be reflected in the new share price, increasing the
share price to
Rs 2.63 + [Rs 8m / (16m shares + 8m new shares)] = Rs 2.96
Debt finance
If debt finance is used to fund the new project, the share price should rise after the
project has been taken on, to reflect the NPV of the new project.
Expected share price = Rs 2.70 + (Rs 8m / 16m shares) = Rs 3.20
Post project ratios – using debt finance:
Interest cover = V19m / Rs 5.2m = 3.65 times
Earnings per share (EPS) = Rs 9.7m / 16m = 60.6 cents per share
Earnings yield = Rs 0.606 / Rs 3.20 = 0.189, or 18.9%

Eight is NPV
Post project ratios – using equity finance:
Interest cover = Rs 19m / Rs 4m = 4.75 times
Earnings per share (EPS) = Rs 10.5m / (16m + 8m) = 43.8 cents per share
Earnings yield = Rs 0.438 / Rs 2.96 = 0.148, or 14.8%
(b) Debt financing option
If debt is used to fund the new project, the shareholders are likely to see the change in
EPS and earnings yield as positive.
The EPS increase from 48.1 cents per share to 60.6 cents per share, and the earnings
yield increases form 17.8% to 18.9%. This indicates that Seed Co will potentially to
able to pay out a higher dividend to the shareholders in future.
On the other hand, the reduction in interest cover indicates that Seed Co will face a
higher level of risk if the debt financing option is used i.e. the chance of Seed Co being
unable to meet its interest obligations is higher. The higher risk to shareholders could
lead to a fall in the share price if considered to be significant.
However, in practice it is unlikely that this issue will worry either the shareholders or
the lenders greatly, given that the movement in interest Cover is extremely small (3.75
to 3.65 times).
Overall, it is likely that both shareholders and lenders will be quite happy with the EPS,
earnings yield and interest cover ratios if the debt finance option is used (assuming
that the expected Rs 4m increase in profit and Rs 8m NPV are achieved).
Equity finance option
The lenders will be happy if the rights issue goes ahead, because there will be no
additional interest payable and yet profits will increase, so the interest cover ratio will
rise significantly. This means that the chances of Seed CO defaulting on its interest
payments will be less if this options goes ahead.
All first glances, it appears that the shareholders will not be happy with this option,
given that EPS reduces form 48.1 cents per share to 43.8 cents per share, and also
given that earnings yield falls from 17.8% to 14.8%.
However, in this situation, where a 1 for 2 rights issue has been used, a shareholder’s
who owned 2 shares before the rights issue will now own 3 shares (assuming he took
up his rights). The rights issue itself makes no difference to the shareholder’s return or
wealth. However, the positive NPV of the project undertaken causes the shareholder
return and wealth to increase.
The increase in earnings attributable to each shareholder’s shareholding will be viewed

positively by shareholders, who might expect to see increased overall dividends in the
future.
Once again, overall it is likely that both shareholders and lenders will be quite happy
with the EPS, earnings yield and interest cover ratios if this financing option is used
(assuming that the expected Rs 4m increase in profit and Rs 8m NPV are achieved).
The impact of capital structure on WACC and company value
When we consider the WACC formula which was introduced in the previous chapter, it
is clear that if a company changes its capital structure (gearing level), the WACC will
change, since the ratio of debt to equity is a key variable in the formula.
Also, since the value of a company is the present value of its cash flows discounted at
the WACC, as the WACC changes so does the value.
Several studies have focussed on this link between capital structure and company
value. The key question is:
"What capital structure should the company aim for in order to maximise the
company's value?"
The main studies are:
 the traditional view;

 the Modigliani-Miller view (or net operating income view),
ignoring taxation;
 the Modigliani-Miller view, taking into account the tax relief on debt interest
payments.
These studies are based on different assumptions and come to different conclusions.
They are covered below.
In order to understand the different views, it is vital to understand the two opposing
forces which impact on the WACC as capital structure changes.
The two opposing factors which impact WACC

Impact on WACC of an increase in gearing
In general, the entity’s cost of debt finance is cheaper than its cost of equity finance, for
two reasons:
 Interest is an obligation which has to be paid out each year, whereas dividends
are paid only if the company can afford them. This means that debt holders face
less risk, so accept lower returns.
 Interest is a tax deductible expense, whereas dividends are paid out of post tax
profits. This further reduces the cost of debt for the company
Therefore, as the entity increases its gearing by raising more debt fiancé, the greater
proportion of (cheaper) debt in the capital structure exerts a downward force on the
WACC.
Upward force on the WACC
As the gearing level increases, the extra interest payments to debt holders mean that
the likelihood of the entity being able to afford to pay dividends to shareholders
reduces. This increases the risk perception of the shareholders, so they demand
higher return to compensate for the increased risk.
This increase in the cost of equity exerts an upward force on the WACC.
Net effect
Clearly, the two factors identified have opposing impacts on the weighted average cost
of capital. The key questions are:
 Which of the two forces is stronger?

 What is the net effect of these two factors?
There is no simple answer to these questions. In fact, the different gearing theories
propose different answers to the questions, based on different assumptions.
However, an understanding of these two factors, and these key questions, is crucial to
a sound understanding of the capital structure theories covered in this Chapter.
Impact of capital structures on the equity investor

High gearing exists when an entity has a large proportion of prior charge capital in
relation to equity a low gearing exists when there is a small proportion of prior charge
capital. High gearing increases the financial risk of the equity investor but the reward
can be in the form of increased dividends when profits rise. If, however, profits falter,
the equity investor can expect to be the first to feel the effect of the first to feel the
effect of the reduction in profits.
Low gearing or no gearing may not necessarily be in the equity investor’s best interests
because the entity might then be failing to exploit the benefits with borrowing can bring.
Provided that the return generated form borrowed funds is greater than the cost of
those funds, capital gearing could be increased. The extent to which it is prudent for an
entity to increase its capital gearing will depend upon many variables such as the type
of industry within which the entity operates, the cost of funds in the market, the
availability of investment opportunities and the extent to which the company can
continue to benefit from the ‘tax shield’.
The ordinary share price of highly geared entities will tend to be depressed in times of
rising interest rates.
3 Traditional View
According to the 'traditional' view of gearing and the cost of capital, as an organisation
introduces debt into its capital structure the weighted average cost of capital will fall
because initially the benefit of cheap debt finance more than outweighs any increases
in the cost of equity required to compensate equity holders for higher financial risk.
As gearing continues to increase the equity holders will ask for increasingly higher
returns. The cost of equity therefore rises as gearing increases. Eventually this
increase in the cost of equity will start to outweigh the benefit of cheap debt finance,
and the weighted average cost of capital will rise. 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.
The diagram below demonstrates this position in which:
 ke is the cost of equity;

 kd is the cost of debt;
 ko is the overall or weighted average cost of capital.
Traditional view of
gearing and the cost
of capital
X = optimal level of gearing, where ko is at a minimum.
The traditional view therefore claims that there is an optimal capital structure where the
weighted average cost of capital is at a minimum. This is at point X in the above
diagram.
At point X the overall return required by investors (debt and equity) is minimised.
It follows that at this point the combined market value of the firm's debt and equity
securities will also be maximised. (If investors are offered the same Rs return but the
% return they require has fallen, market pressures will make the value of the securities
rise.)
Optimal capital structure

4 Capital Structure – Modigliani And Miller's View
In 1958, the two American economists, Professors Modigliani and Miller, challenged
the traditional view of gearing and the cost of capital. Over a 20-year period they put
forward a number of propositions as to why the traditional view of gearing might be
wrong. They began by assuming that the effect of tax relief on debt interest could be
ignored.
The Modigliani and Miller (M & M) first proposition was that companies which operate
in the same type of business and which have similar operating risks must have the
same total value, irrespective of their capital structures.
Their view is based on the belief that the value of a company depends upon the future
operating income generated by its assets. The way in which this income is split
between returns to debt holders and returns to equity should make no difference to the
total value of the firm (equity plus debt). Thus, the total value of the firm will not change
with gearing. This means that its weighted average cost of capital will not change with
gearing, and will be the same at all levels of gearing.
Their view is represented in the following diagrams.
Modigliani and Miller view (no taxation)

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. The essential point made by M & M is that, ignoring taxation, a
firm should be indifferent between all possible capital structures. This is at odds with
the beliefs of the traditionalists.
M & M support their case by demonstrating that market pressures will ensure that two
companies identical in every aspect apart from their gearing level will have the same
overall market value.
Modigliani and Miller with tax
In their original 'proposition 1' model M & M ignored taxation (tax relief on debt
interest). In 1963 they amended their model to include corporation tax. This alteration
changes the implication of their analysis significantly.
Previously they argued that companies that differ only in their capital structure should
have the same total value of debt plus equity. This was because it was the size of a
firm's operating earnings stream that determines its value, not the way in which it was
split between returns to debt and equity holders. However, the corporation tax system
carries a distortion under which returns to debt holders (interest) are tax deductible for
the firm, whereas returns to equity holders are not. M & M, therefore, conclude that
geared companies have an advantage over ungeared companies, i.e. they pay less
tax and will, therefore, have a greater market value and a lower weighted average cost
of capital.
Graph of M & M model with tax

As gearing increases, the WACC steadily decreases.
If the other implications of the M & M view are accepted, the introduction of taxation
suggests that the higher the level of taxation, the lower the combined cost of capital.
Modigliani and Miller (M & M) formulae
M & M developed the following formulae that can be applied to finding the value, cost
of equity or WACC of firms that have a given level of business risk, but varying
financial risk.
With tax
Value of firm Vg = Vu + TB
Cost of equity Keu+(Keu-Kd)xVD keg = keu + (keu - kd) VD(1 - t) / VE
(1-t)/VE
WACC kadj = keu (1 - tL)
where V = Value of firm (Vg = value of geared firm, Vu = value of ungeared firm)
ke = Cost of equity (keg = cost of equity in geared firm, keu = cost of equity in
ungeared firm)
kd = Cost of debt (must be gross of tax)

VD = MV of debt
VE = MV of geared firm's equity
T, t= Corporation tax rate
WACC = weighted average cost of capital
The without-tax formulae are simply a special case of the with-tax formulae, where t =
0.
Interpreting the M & M graphs and formulae
Without tax
Company value (Vg = Vu)
The graph showed a horizontal line for company value in the M & M without tax theory.
This is backed up by the formula, which shows that if T= 0, the values of an ungeared
company and an equivalent unguarded company are the same.
WACC (Kadj = Keu)
The graph also showed a horizontal line for WACC in the M & M without tax theory.
Again, the formula backs this up. If t = 0, the formula reduces to kadj = keu. This shows
that the WACC of the geared company is always the same as the WACC of an
equivalent unguarded company, irrespective of the level of gearing.
With tax
Company value (Vg = Vu + TB)
The graph showed an upward sloping line for company value in the M & M with tax
theory.
This is backed up by the formula, which shows that the higher the value of B (value fo
debt), the greater the value of the entire company should be.
As the company increases its gearing, the value of the entire company (debt plus
equity) increases.
Cost of equity (keg = keu + (Keu – kd) VD(1-t)/VE)
The cost of equity slopes upwards as gearing increases under M & M’s assumptions,
because shareholders face higher risk so demand higher returns.
We can form the formula that the Keg increases as the amount of debt (VD) increase
relative to the value of equity (VE).
Note that the inclusion of (--t) in the formula has the impact of reducing the slope of the
line if the tax rate increases. Most importantly, this means that the cost of equity in the
M & M with tax theory will always increase less steeply than in the without tax theory.
This helps to explain way the upward force on WACC is smaller in the with tax theory,
and, and hence why the downward force on the WACC caused by the (net of tax)
cheep debt fiancé is the net stronger force in the with tax theory.
WACC (Kadj = Keu (1-tL))
The formula shows that WACC will reduce as gearing (measured by L) increases. This
is seen on the graph as a downward sloping line.
Example 1 – M & M without tax
X Co is identical in all operating and risk characteristics to Y Co, except that X Co is

all equity financed and Y Co is financed by equity valued at Rs 2.1m and debt
valued at Rs 0.9m based on market values. X Co and Y Co operate in a country
where no tax is
(i) A perfect capital market in which there are no information costs or transaction
costs.
(ii) Investors are indifferent between personal and corporate gearing.
(iii) Investors and companies can borrow at the same rate of interest.
(iv) kd remains constant at all levels of gearing.
The traditional view can be criticised as there is no underlying analysis to support it.
Nor is there any evidence that the WACC is a U-shaped function in practice. This then
leaves the problem of how companies are to determine their capital structure in
practice. Management takes five factors into account in reaching a judgement on
capital structure:
(i) The risks of bankruptcy
Direct costs
These are costs associated with a company being in liquidation:
– distress sale price of the assets;

– liquidators' fees.
Indirect costs
These are costs associated with a company being in severe financial

distress:
– loss of credit from suppliers;

– loss of customers;
– loss of key staff;
– lack of future finance.
(ii) The 'agency costs' (such as tight bank control) associated with gearing.
(iii) The company's ability to obtain interest tax relief by having sufficient off-
setting tax liability. (The problem of 'tax exhaustion'.)
(iv) Constraints imposed on the level or gearing, either by:
(1) Articles of Association; or
(2) loan agreement conditions.
(v) The company's ability to borrow money: the company's 'debt capacity'.
5 Real world approaches to the gearing question
Static trade-off theory
It is possible to revise M and M’s theory to incorporate bankruptcy risk and so to

arrive at the same conclusion as the traditional theory of gearing – i.e. that an optimal
gearing level exists.
Given this, firms will strive to reach the optimum level by means of a trade-off.
Static trade-off theory argues that firms in a stable (static) position will adjust their
current level of gearing to achieve a target level:
Above target debt ratio the value of the firm is not optimal:
• Financial distress and agency costs exceed the benefits of debt.

• Firms decrease their debt levels.
Below the target debt ratio can still increase the value of the firm because:
• marginal value of the benefits of debt are still greater than the costs associated
with the use of debt
• firms increase their debt.
NB: Research suggests that this theory is not backed up by empirical evidence.
Pecking order theory
Pecking order theory tries to explain why firms do not behave the way the static
trade-off model would predict. It states that firms have a preferred hierarchy for
financing decisions:
The implications for investment are that:
 the value of a project depends on how it is financed

 some projects will be undertaken only if funded internally or with relatively safe
debt but not if financed with risky debt or equity
 companies with less cash and higher gearing will be more prone to underinvest.
If a firm follows the pecking order:
• its gearing ratio results from a series of incremental decisions, not an attempt to
reach a target
– High cash flow ⇒ Gearing ratio decreases

– Low cash flow ⇒ Gearing ratio increases
• there may be good and bad times to issue equity depending on the degree of
information asymmetry.
A compromise approach
The different theories can be reconciled to encourage firms to make the correct
financing decisions:
(1) Select a long run target gearing ratio.

(2) Whilst far from target, decisions should be governed by static trade-off theory.
(3) When close to target, pecking order theory will dictate source of funds.
More on pecking order v static trade-off
Pecking order theory was developed to suggest a reason for this observed
inconsistency in practice between the static trade-off model and what companies
actually appear to do.
Internally generated funds have the lowest issue costs, debt moderate issue costs
and equity the highest. Firms issue as much as they can from internally generated
funds first then move on to debt and finally equity.
Myers has suggested asymmetric information as an explanation for the heavy

reliance on retentions. This may be a situation where managers, because of their
access to more information about the firm, know that the value of the shares is
greater than the current market value based on the weak and semi-strong market
information.
In the case of a new project, managers forecast maybe higher and more realistic
than that of the market. If new shares were issued in this situation there is a
possibility that they would be issued at too low a price, thus transferring wealth from
existing shareholders to new shareholders. In these circumstances there might be a
natural preference for internally generated funds over new issues. If additional funds
are required over and above internally generated funds, then debt would be the next
alternative.
If management is against making equity issues when in possession of favourable

inside information, market participants might assume that management would be
more likely to favour new issues when they are in possession of unfavourable inside
information. This leads to the suggestion that new issues might be regarded as a
signal of bad news!
Managers may therefore wish to rely primarily on internally generated funds
supplemented by borrowing, with issues of new equity as a last resort.
Myers and Majluf (1984) demonstrated that with asymmetric information, equity
issues are interpreted by the market as bad news, since managers are only
motivated to make equity issues when shares are overpriced. Bennett Stewart (1990)
puts it differently: ‘Raising equity conveys doubt. Investors suspect that management
is attempting to shore up the firm’s financial resources for rough times ahead by
selling overvalued shares.’
Asquith and Mullins (1983) empirically observed that announcements of new equity
issues are greeted by sharp declines in stock prices. Thus, equity issues are
comparatively rare among large established companies.
Dealing with 'gearing drift'
Profitable companies will tend to find that their gearing level gradually reduces over
time as accumulated profits help to increase the value of equity. This is known as
"gearing drift".
Gearing drift can cause a firm to move away from its optimal gearing position. The
firm might have to occasionally increase gearing (by issuing debt, or paying a large
dividend or buying back shares) to return to its optimal gearing position.
Signalling to investors
In a perfect capital market, investors fully understand the reasons why a firm
chooses a particular source of finance.
However, in the real world it is important that the firm considers the signalling effect
of raising new finance. Generally, it is thought that raising new finance gives a
positive signal to the market: the firm is showing that it is confident that it has
identified attractive new projects and that it will be able to afford to service the new
finance in the future.
Investors and analysts may well assess the impact of the new finance on a firm's
statement of profit or loss and balance sheet (statement of financial position) in order
to help them assess the likely success of the firm after the new finance has been
raised.
6 Risk adjusted WACC – a project specific cost of capital

Introduction
An important application of the M & M theories and formulae is in the calculation of

project specific discount rates.
In the earlier Chapter on 'Cost of Capital' it was noted that the existing cost of capital
(WACC) of an entity is unsuitable as a project discount rate if the business risk of the
new project and / or the entity's capital structure will change as a consequence of
taking on the project.
Using the M & M theories and the CAPM model, a project specific discount rate (or risk
adjusted WACC) can be calculated in these circumstances.
Asset betas, equity betas and debt betas
In order to understand the risk adjusted WACC method, we first need to expand our
understanding of beta factors which were introduced earlier in the 'Cost of Capital'
Chapter.
• The beta factor is a measure of the systematic risk of an investment relative to the
market.
• This risk will be dependent on the level of business risk and the level of financial risk
(gearing) associated with an investment.
• Hence, the beta factor for a geared company will be greater than the beta factor for
an equivalent ungeared company.
The relationship between the beta factors for ungeared and geared companies is given
by the following formula:
βu = βg x + βd x
where
βg = the equity (geared) beta measures the systematic business risk and the
systematic financial risk of a company's shares
βu = the asset (ungeared) beta measures the systematic business risk only
βd = the debt beta measures the risk associated with the debt finance.
Usually we assume that debt is risk free and hence the debt beta is zero. If this is the
case, the second term in the given formula disappears and the formula becomes:
βu = βg x
More on systematic risk
We know from the earlier ‘Cost of Capital’ Chapter that what is important is an
investment’s systematic risk.
Remember:
 Shareholders are only interested in systematic risk because they hold well-diversified
portfolios. Systematic risk of a project is measured by its beta.
 Shareholders in a geared company suffer two types of systematic risk i.e. business
and financial risk.
 The business risk of a company refers to the risk of the operating cash flows.
 Financial risk is the increased volatile of dividend payments to shareholders as

gearing increases.
From the M & M analysis, we know that a share’s systematic risk can be split up
between the systematic business risk and the systematic financial risk.
Systematic business risk arises out of the risky nature of the company’s business
caused by:
 Revenue sensitivity;
 Proportion of fixed variable production costs.

Systematic financial risk arises out of how the company has financed itself – its gearing
or capital structure.
Use of the formula
For example, suppose a question tells you that the ABC company has a gearing ratio
(D : E) of 1 : 2; the shares have a beta value of 1.45 (the equity beta); and the
corporation tax rate is 30%. Then:
Geared is the equity
βu = 1.45 x = 1. 074
Note: If a question only states the beta, assume it is an equity beta. Also, if there is no
mention of a debt beta, assume it is zero.
This indicates that shareholders in ABC have a beta value/systematic risk exposure of
1.45. Of this value, 1.074 arises out of the risky nature of the company's business
(its business risk) and the rest (i.e. 1.45 – 1.074 = 0.376) arises out of the financial
risk caused by the company's capital structure.
Notice four very important implications of this analysis:
(1) A company's equity beta will always be greater than its asset beta, except
(2) If it is all equity financed (and so has no financial risk), when its equity beta
and asset beta will be the same.
(3) Companies in the same 'area of business' (i.e. same business risk) will have
the same asset beta, but
(4) Companies in the same area of business will not have the same equity beta
unless they also happen to have the same capital structure.
As we shall see, the third of these points is particularly important.
Risk adjusted WACC – Gearing and ungearing beta factors
There are two ways in which the gearing / degearing formula above can be used in
order to derive a project specific cost of capital:
Method 1: Use the formula (if necessary) to derive the ungeared beta factor, then
regear this beta to reflect the entity's capital structure. Then use CAPM to derive a risk
adjusted cost of equity and use this ke in the standard WACC formula to find risk
adjusted WACC.
Method 2: Use the formula (if necessary) to derive the ungeared beta factor, then
use CAPM to find an "ungeared cost of equity" (keu). Finally, use M & M's WACC
formula (introduced earlier in this Chapter) to calculate the risk adjusted WACC.
Both methods will now be illustrated, to show that they give the same answer.
Illustration 3 – Risk adjusted WACC
Garvey Co is planning to undertake a new project in a new business sector.

Information for Garvey Co and for Rocket Co, a listed company in the new business
sector is as follows:
Garvey Rocket
Co Co
Current geared (equity) beta 1.25 1.86
Current capital structure ratio (D:E by market value) 1:2 1:1
Garvey Co intends to finance the project to maintain its existing gearing ratio.
The tax rate is 30% and the return on the stock market has been 12% per annum in
recent years. Debt is assumed to be risk free and has a pre tax cost of 5% per annum.
Required:
Calculate a suitable cost of capital for the new project.
Solution
Method 1:
Step 1
Rocket Co's ungeared / asset beta is calculated and then used as an estimate of the
project's asset beta (because the project and Rocket Co are in the same area of
business and so will have the same asset beta). Since debt is risk free, use
βu = βg x
βu = βg x = 1.09
Step 2
A geared / equity beta for the project is calculated next. As we know, an equity beta
reflects both systematic business risk and systematic financial risk. The project's equity
beta will reflect the project's business risk and the capital structure of Garvey Co the
company that is to undertake the project.
βu = βg x
1.09 = βg x
So βg = 1.47
Step 3
This equity beta is then input into the CAPM to give a cost of equity capital for the
project (the return required on the shareholders' funds invested by Garvey Co in the
new project:
ke = RF + [ RM – RF] βg
ke PROJECT = 5%+ [12% – 5%] × 1.47 = 15.3%
Step 4
The risk adjusted WACC is now calculated using the standard WACC formula:
= 15.3% × (2/3) + 5% × (10.30) × (1/3) = 11.4%
Method 2:
Step 1
As above, the existing geared / equity beta of Rocket Co is degeared, to give an

ungeared / asset beta of 1.09.
Step 2
Input this ungeared beta into the CAPM formula to give an ungeared cost of equity
(keu)
keu= 5%+ [12% – 5%] × 1.09 = 12.6%
Step 3
Use the M & M WACC formula to find the risk adjusted WACC
kadj = keu (1 – tL)

=12.6% (1 – 30% × (1/3)) = 11.4% as before.
Example 3
ABC is a cement company with a D : E ratio of 1 : 3. It wishes to evaluate a project in

the telecoms industry and does not intend to change its capital structure.
XYZ is a 'typical' telecoms company. It has an equity beta of 1.25 and a D : E ratio of 1
: 2.
Assume that RF = 6%, RM = 14%, and the tax rate is 30%. It is assumed that corporate
debt is risk-free (and so the debt beta is zero).
Required:
Calculate a risk adjusted WACC for the new project
Only Rehan and Mehran related answer is there.....

7 Exam style questions
Test your understanding 1 – Metro Ltd
The finance director of Metro Ltd, a company listed on the AIM (Alternative Investment
Market), wishes to estimate what impact the introduction of debt finance is likely to
have on the company's overall cost of capital. The company is currently financed only
by equity.
Metro Ltd Summarised capital structure
Rs 000
Ordinary shares (Rs 10 par value) 500
Reserves 1,100
———
1,600
———
The company's current share price is Rs 168 , and up to Rs 4 million of fixed rate
irredeemable debt could be raised at an interest rate of 10% per annum. The corporate
tax rate is 33%.
Metro's current earnings before interest and tax are Rs 2.5 million. These earnings are
not expected to change significantly for the foreseeable future.
The company is considering raising either:
(i) Rs 2 million in debt finance;

(ii) Rs 4 million in debt finance
In either case the debt finance will be used to re-purchase ordinary shares.
Required:
(a) Using Miller and Modigliani's model in a world with corporate tax, estimate the
impact on Metro's cost of capital of raising:
(i) Rs 2 million; and
(ii) Rs 4 million in debt finance.
State clearly any assumptions that you make.
(b) Briefly discuss whether or not the estimates produced in part (a) are likely to
be accurate.
Test your understanding 2 – REHAN Ltd
REHAN Ltd manufactures machine tools. It has 200,000 ordinary Rs 10 shares in

issue, quoted at Rs 16.8 each, and Rs 1 million 10% secured debentures quoted at
par. To finance expansion the directors of the company want to raise Rs 1 million for
additional working capital.
Cash flow from trading before interest and tax is currently Rs 1 million per annum. It is
expected to rise to Rs 1.3 million per annum if the expansion programme goes ahead.
To simplify placing a valuation on the company's equity, you should assume that:
· the forecast level of cash flow, and a tax rate of 33%, will continue indefinitely;
· the required rate of return on the market value of equity, 18% post tax, will be
unaffected by the new financing;
· there is no difference between taxable profits and cash flow.
The company's directors are considering two forms of finance - equity via a rights issue
at 15% discount to current share price, or 12% unsecured loan stock at par.
Required:
(a) Calculate for both financing options, the expected:

(i) increase in the market value of equity;
(ii) debt: debt + equity ratio;
(iii) weighted average cost of capital.

(13 marks)
(b) Assume you are the financial manager for REHAN Ltd. Write a report to the board
advising which of the two types of financing is to be preferred. Include in your report
brief comments on non-financial factors which should be considered by the directors
before deciding how to raise the Rs 1 million finance.
(12 marks)
(Total: 25 marks)
Test your understanding 3 – Mehran Ltd
Mehran Ltd has annual earnings before interest and tax of Rs 15 million. These
earnings are expected to remain constant. The market price of the company's ordinary
shares is Rs 34.4 per share cum div and of debentures Rs 105.50 per debenture ex
interest. An interim dividend of Rs 2.4per share has been declared. Corporate tax is at
the rate of 35% and all available earnings are distributed as dividends.
Mehran’s long-term capital structure is shown below:
Rs 000
Ordinary shares (Rs 10 par value) 12,500
Reserves 24,300
———
36,800
16% debenture 31.12. × 4 (Rs 100 par value) 23,697
———
This means these are redeemable
60,497
———
Required:
(a) Calculate the cost of capital of Mehran Ltd according to the traditional theory of
capital structure. Assume that it is now 31 December 20X1. (8 marks)
(b) Canal Ltd is an all equity company with an equilibrium market value of Rs 32.5
million and a cost of capital of 18% per year.
The company proposes to re-purchase Rs 5 million of equity and to replace it with

13% irredeemable loan stock.
Canal's earnings before interest and tax are expected to be constant for the
foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as
dividends.
Explain and demonstrate how this change in capital structure will
affect:
(i) the market value;

(ii) the cost of equity; and
(iii) the cost of capital
of Canal Ltd, using the assumptions of Modigliani and Miller.

(7 marks)
(c) Explain any weaknesses of both the traditional and Modigliani and Miller theories
and discuss how useful they might be in the determination of the appropriate capital
structure for a company.
(10 marks)
(Total: 25
marks)
Multiple choice questions (MCQs):

1. Weighted average cost of capital is constant at any gearing level, is the

concept of:
A) Traditional view
B) M&M without tax
C) M&M with tax
D) None of the above
2. M&M assume that tax benefits will result in:
i) Increase in weighted average cost of capital

ii) Increase in value of business
iii) Decrease in weighted average cost of capital
iv) Decrease in value of business
A) (i) and (ii)

B) (i) and (iv)
C) (ii) and (iii)
D) (iii) only
Test your understanding answers

Example 1 – M & M without tax
(a) Vg = Vu + TB
so given that T = 0,
Vg = Vu
so the value of X Co is the same as the value of Y Co, (Rs 2.1m + Rs 0.9m) Rs 3m
(b) Assuming no growth in dividends, using the dividend valuation model,

keu = Dividend / VE = 450,000 / 3,000,000 = 15%
(c) Cost of debt for Y Co (assuming debt is irredeemable)
kd = Interest / VD = 72,000 / 900,000 = 8%
Cost of equity for Y Co:
Using M & M's formula:
keg = keu + (keu – kd) VD(1 - t) / VE
keg = 15% + (15%–8%) × 0.9/2.1 = 18%
(Alternatively, using the dividend valuation model,
keg = Dividend / VE = 378,000 / 2,100,000 = 18%)
As shown on the graphs, the geared company has a higher cost of equity.
(d) Weighted average cost of capital:
WACC = (18% × 2.1 / 3) + (8% × 0.9 /3) = 15%
Again, notice that this corresponds to the graphs seen above. In the no tax case, the
WACC is constant irrespective of capital structure.
Example 2 – M & M with tax

(a) Vg = Vu + TB
so given that T = 0.33,

Vg = 3,000,000 + (33% × 900,000) = Rs 3,297,000
so the value of the equity = 3,297,000 – 900,000 (value of debt) = Rs 2,397,000
(b) Assuming no growth in dividends, using the dividend valuation model,
keu = Dividend / VE = 450,000 / 3,000,000 = 15%
(c) Cost of debt for Y Co (assuming debt is irredeemable)
kd = Interest / VD = 72,000 / 900,000 = 8%
Cost of equity for Y Co:
Using M & M's formula:
keg = keu + (keu – kd) VD(1 – t) / VE
keg = 15% + (15%–8%)×900,000×(1 – 0.33)/2,397,000 = 16.76%
As shown on the graphs, the geared company has a higher cost of equity.
(d) Weighted average cost of capital:
WACC = (16.76% × 2,397 / 3,297) + (8% × (1 – 0.33) 900 /3,297) = 13.65%
Alternatively, using M & M's formula:
kadj = keu (1 – tL) = 15% (1 - 33% × 900 / 3,297) = 13.65%
Again, notice that this corresponds to the graphs seen above. In the with tax case,
the WACC reduces as the level of debt in the capital structure increases.
With Rs 4 million debt
V geared = 8,400 + (4,000 × 0.33) = 9,720

Rs 000
Total value of the company 9,720

Market value of debt 4,000
––––
Value of equity 5,720
––––
Rs 2 million debt:
Rs 4 million debt:
(i) They rely on the assumptions of the Modigliani and Miller (M & M) model,
many of which are unrealistic such as the capital market is perfectly efficient, debt is
risk free, information is costless and readily available, there are no transaction costs,
investors are rational and make the same forecasts about the performance of
companies, and investors and companies can borrow at the risk-free rate.
(ii) Only corporate taxation is considered and not the impact of other forms of taxation
including personal taxation.
(iii) M & M assumed that debt is permanent. Metro's debt has a five-year time horizon.
(iv) The estimates ignore possible costs that might be incurred as gearing increases,
which would reduce share price and increase the cost of equity (and possibly debt).
These include bankruptcy costs, agency costs and tax exhaustion.
(v) Inaccuracies exist in the measurement of the data required for the model.
Test your understanding 2 – REHAN Ltd

(a)
(i)
Rights issue Loan stock

MV equity
Extra dividends Rs 300,000 × 67% Rs (300,000 – 120,000) × 67%
= Rs 201,000 = Rs 120,600
Rs 201,000 Rs 120,000
PV at 18% ———— ————
0.18 0.18
= Rs 1,116,667 = Rs 670,000
The market value of equity will rise by Rs 1.117m under the rights issue financing
option (yielding a net gain to shareholders of Rs 0.117m after the rights price of Rs 1m)
and by Rs 0.67m under the Loan stock option (which is also their gain).
(ii) Debt: debt + equity ratio
Current MV equity = 200,000 × Rs 16.8 = Rs 3.36m

Market values after expansion (Rs m)
Equity 3.36 + 1.117 = 3.36 + 0.67 =
4.477 4.03
10% secured debentures 1000 1.00
12% unsecured loan − 1.00
stock
——— ———
5.477 6.03
——— ———
Debt: debt + equity ratio 1: 5.477 (18.3%) 2 : 6.03 (33.2%)
(iii) WACC
MV Cost WACC MV Cost WACC
(Rs m) % % Rs m % %
Equity 4.477 18 14.71 4.03 18 12.03
10% secured 1.000 6.7 1.22 1.00 6.7 1.11
weightage
12% unsecured − 1.00 8.04 1.33

loan stock
——– ——– ——– ——–
5.477 15.93 6.03 14.47
——– ——– ——– ——–
The WACC will be 15.93% under the rights issue option and 14.47% under the
loan stock option.
(b)
Report
To: Board of Directors, REHAN Ltd
From: Financial manager
Date: XX/XX/XX
Re: Finance options for expansion project
The company wishes to raise Rs 1m to fund our proposed expansion. This report
initially assesses the two methods of finance currently being considered - a rights
issue or issue of unsecured loan stock. I will then outline non-financial factors
that I believe you should consider before making the final decision.
Evaluation of the two methods of finance
I have assessed the two proposed methods on the basis of their impact on the
market value of equity, the gearing level and the WACC.
The results of my computations are as follows:

Current With project With project
and and
Right issue loan stock
MV equity (Rs m) 3.36 4.477 4.03

representing
an increase of 1.117 0.67
a gain to 0.117 0.67
shareholders of
Gearing
(debt:debt + equity) 01:04.4 01:05.5 01:03.0
(22.90%) (18.30%) (33.20%)
WACC 15.41% 15.93% 14.47%
On the basis of these figures, to give maximum gain to our shareholders, the loan stock
option should be chosen. This will also raise our gearing level and lower our WACC.
However, it should be noted that the impact of changes in gearing on the cost of equity
has been ignored in this analysis. It is likely that an approximate 50% rise in gearing
(from 22.9% to 33.2%) under the loan stock option will lead to an increase in the cost of
equity above the current 18%, to compensate for the additional risk borne by the
shareholders.
This will have the effect of lowering the value placed on the additional dividends by
shareholders (thus reducing their gain) and limiting the fall in WACC (although, with tax
relief on debt interest, this is still likely to be below the current cost).
Other considerations
First, alternative methods of finance that may be considered, (particularly as it is to

fund working capital), include a bank overdraft, a medium-term loan or invoice
discounting. Other non-financial factors:
– whether the issue of loan stock now will limit the availability of such finance in
the future, when this longer term form of finance may be more appropriate;
– whether the rights issue is likely to be successful in the current market climate.
If the company has a small number of shareholders, it may be possible to talk
to them directly;
– whether the rights issue will be regarded as a positive move by the market or
whether it might signal financial difficulties - this can be pre-empted by ensuring
shareholders are made fully aware of the reasons for the additional finance
being needed;
– the extent to which you feel you can rely on the cash flow estimates built into
the appraisal.
Test your understanding 3 – Mehran Ltd
(a) Cost of equity
All available earnings are distributed as dividends and earnings are expected to remain
constant.
D
∴Ke = — , where D is the annual dividend
Ve
Ve is the ex dividend market value of equity
Ve = (Cum div share price - interim dividend) number of

shares
= (Rs 34.4 – Rs 2.4) × (12,500,000 ÷ 10)
= Rs 40 million
The dividends may be calculated as follows:
Rs 000
Earnings before finance charges and tax 15,000
Debenture interest (Rs 23,697,000 16%) (3,792)
———
11,208
Tax @ 35% (3,923)
———
7,285
———
7,285
Ke = ——— ≡ 18.2%
40,000
Cost of debt
The cost of debt is equivalent to the internal rate of return of the following cash
flows:
31 Dec 20X1 Market value ex int (Rs 105.50)

31 Dec 20X1 - X4 Finance charge less tax Rs 16 × 0.65 = Rs 10.40
31 Dec 20X4 Redemption value Rs 100.
The net present values are calculated using discount rates of 8% and 10% as
follows:
At 8% At 10%
t0 (Rs 105.50) (Rs 105.50) × 1 = (Rs 105.50) (Rs 105.50) × 1 = Rs 105.50)
t1-3 Rs 10.40 Rs 10.40 × 2.577 = Rs 26.80 Rs 10.40 × 2.487 = Rs 25.86
t3 Rs 100 Rs 100 × 0.794 = Rs 79.40 Rs 100 × 0.751 = Rs 75.10
——— ———
Rs 0.70 (Rs 4.54)
——— ———
The internal rate of return is given by:
0.70
8% + ————— × 2% = 8.2%
0.70 + 4.54
∴Kd ≈ 8.2%
Cost of capital
The market value of equity = Rs 40m from above.
The market value of debt = Rs 23.697m × 1.055 = Rs 25m.
The weighted average cost of capital is therefore given by:
40 25
WACC = Ke × — + Kd × —
65 65
40 25
= 18.2% × — + 8.2% × — = 14.4%
65 65
(b)
(i) Market value
Modigliani and Miller's hypothesis including the effects of corporation tax suggests that:
Vg = Vu + TB
Where Vg is the value of the geared company
Vu is the value of an equivalent ungeared company
B is the market value of debt
T is the rate of corporation tax
In the case of Canal:
Vu = Rs 32.5 million
B = Rs 5 million
T= 35%
∴Vg = Rs 32.5m + Rs 5m 35% = Rs 34.25m
The original value was Rs 32.5 million.
This therefore represents an increase of Rs 1.75 million.
(ii) Cost of equity
Modigliani and Miller propose the following formula for calculating the cost of equity of
a geared company:
Vd
Keg = Keu + ( Keu – Kd) × — × (l – t)

Ve
where Keg is the cost of equity of the geared company
Keu is the cost of equity of an equivalent ungeared

company
Kd is the cost of debt before tax

Vd is the market value of debt
Ve is the market value of equity
t is the rate of corporation tax
Keu = 18% (given)
Kd = 13%
Vd= Rs 5m
Ve = Vg – D = Rs 34.25m Rs 5m = Rs 29.25m
5
∴ Ke = 18% + (18% – 13%) ——– × (1 – 0.35)
29.25
= 18.56%.
The cost of equity has increased by 0.56%, reflecting the

increase in financial risk as a result of gearing.
(iii) Cost of capital
Using Modigliani and Miller's formula:
 Dt 
 K eu 1  
 D  Ve 
 5  0.35 
 18% 1 
 34.25 
 17.08%
Alternatively the traditional weighted average cost of capital

formula may be used, i.e.
29.25 5
WACC = 18.56% × ——— + 13%(1 – 0.35) × ——–
34.25 34.25
= 17.08%
The previous WACC was equal to Keu, i.e. 18%. It has therefore
decreased by 0.92%, reflecting the tax benefits of increased
gearing.
(c) The traditional view of capital structure theory is intuitive only; it is not based on
any empirical evidence or computation and therein lies its major weakness.
It argues that there exists an optimal capital structure where the overall cost of capital
is minimised and thus the company value is maximised. This is based on the following
propositions:
– as gearing increases the cost of equity rises due to the increase in financial risk,
but this is outweighed by the cost of debt and so the overall cost of capital
decreases;
– as gearing continues to increase the cost of equity rises more sharply, such that
this effect is greater than the effect of the lower cost of debt and the cost of
capital rises;
– therefore there exists a minimum optimal cost of capital.
The theory is useful in as much as it highlights the fact that financing and capital
structure may affect a company's value but it gives no
suggestion as to where that optimal level lies.
Modigliani and Miller's theory, however, was initially based on empirical evidence and
followed by quantification. Their hypothesis which includes the effects of corporate
taxes (an adjustment to their original model) suggests that the optimal capital
structure comprises 99.9% debt. Since this policy is not adopted by companies there
must be certain flaws in this theory, the most important of which was later corrected
by Miller himself, i.e. the effect of personal taxes.
Other common criticisms of the model include the following:
– the use of unrealistic assumptions, for instance:

– there are no transaction costs;
– information is freely available;
– individuals can borrow on the same terms as companies;
– individuals are prepared to exchange personal gearing for
corporate gearing;
– costs associated with high levels of gearing are not considered.

These may include the following:
(1) Bankruptcy costs
As gearing reaches high levels the probability of bankruptcy increases and if

bankruptcy occurs there will be associated costs. These include the liquidation fees
and the loss on the disposal of assets in a forced sales situation.
(2) Tax exhaustion
The benefit derived from increasing the level of gearing relates to the tax relief
obtained by companies on returns paid to debt, i.e. interest. However, at very high
levels of gearing there is the possibility that the company will not have sufficient
taxable profits from which to deduct the debt interest. In this situation the advantage of
gearing up will be lost.
(3) Agency costs
These relate to constraints imposed on the company by providers of finance through

restrictive covenants contained within terms of agreement. Such constraints are
aimed to protect the interest of (primarily) the debt holders when a company finds
itself in a potentially difficult situation close to bankruptcy.
As a result of the above and the effect of personal taxes, it is clear that benefits
related to increased gearing do not continue indefinitely. The final position is not well
defined, but it may be possible that there exists a point where the cost of capital is
minimised before the additional costs of high gearing outweigh the benefits. Thus, if
managers are able to quantify such costs and benefits, this adapted theory may be of
use to them in identifying an appropriate level of gearing to adopt.
Answers to MCQs:
1) B
2) C

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Chapter 4

Chapter learning objectives

In this chapter you will learn:

 Capital structure decision

2 Changing Capital Structure

Two key measures of gearing:

Illustration 1 - Gearing ratio calculation

Extracts from PPP's statement of financial position show:

Calculate the gearing ratio measured as (debt/(debt + equity)):

(a) before the acquisition of QQQ,

Solution: Gearing based on book values

Pre acquisition 950 / [950 + (500 + 400)] = 51.4%

Gearing based on market values (W2)

Pre acquisition 950 / [950 + 1,450] = 39.6%

(W2) Market value of existing shares = Rs 29 × 50m = Rs 1,450m

Impact on other ratios

Seed Co is considering investment of Rs 20m which is expected to have an NPV of Rs

Extract from the most recent financial statements of Seed Co:

Statement of financial position extracts Rs m

Income statement extracts Rs m

Profit before tax 11.0

The current share price of Seed Co is Rs 2.70 per share.

(a) Pre project ratios:

Interest cover = Rs 15m/Rs 4m = 3.75 times

Earnings yield = EPS / Share price = Rs 0.481 / Rs 2.70 = 0.178, or 17.8%

Income statement Rs m – debt used Rs m – rights issue

Share price workings:

TERP = [(N x cum rights price) + issue price] / (N+1)

=[(2 x 2.70) + 2.50]/3 = Rs 2.63

Rs 2.63 + [Rs 8m / (16m shares + 8m new shares)] = Rs 2.96

Expected share price = Rs 2.70 + (Rs 8m / 16m shares) = Rs 3.20

Post project ratios – using debt finance:

Interest cover = V19m / Rs 5.2m = 3.65 times

Earnings yield = Rs 0.606 / Rs 3.20 = 0.189, or 18.9%

Interest cover = Rs 19m / Rs 4m = 4.75 times

Earnings yield = Rs 0.438 / Rs 2.96 = 0.148, or 14.8%

(b) Debt financing option

Equity finance option

The increase in earnings attributable to each shareholder’s shareholding will be viewed

The impact of capital structure on WACC and company value

The main studies are:

 the traditional view;

The two opposing factors which impact WACC

Impact on WACC of an increase in gearing

Upward force on the WACC

 Which of the two forces is stronger?

Impact of capital structures on the equity investor

The diagram below demonstrates this position in which:

 ke is the cost of equity;

X = optimal level of gearing, where ko is at a minimum.

Optimal capital structure

4 Capital Structure – Modigliani And Miller's View

Their view is represented in the following diagrams.

Modigliani and Miller view (no taxation)

Modigliani and Miller with tax

Graph of M & M model with tax

As gearing increases, the WACC steadily decreases.

Modigliani and Miller (M & M) formulae

kd = Cost of debt (must be gross of tax)