Chapter 10 • Cost of capital estimations and the discount rate
Realities of raising (and repaying) finance and the discount rate
Although businesses seem to establish and maintain a target gearing ratio, the prac-
tical realities of raising and repaying finance are that it is not always economic to raise
(or repay) each £1 of additional (or reduction in) finance strictly in the target pro-
portions. This is because, as we have already seen in Chapter 8, there are quite large
fixed costs associated with raising long-term finance, particularly with share capital.
In practice, businesses seem to raise fairly substantial sums from each issue in order to
take advantage of the economies of scale regarding the issue costs. This would tend to
have the effect that the target is a factor around which the actual ratio hovers.
In the last example, the current ratio of loan notes to total finance for Hazelwood
plc is 29.7 per cent [that is, 0.76/(1.80 +0.76)]. Equity currently accounts for 70.3 per
cent of the total. This suggests a target ratio of about 70/30. If the business wished to
raise £1 million, say, to finance a new investment project, it is most unlikely that it
would raise £700,000 in ordinary shares and £300,000 in loan notes. It is much more
likely that it would raise the whole £1 million from one source or the other. This would
move its gearing ratio away from the 70/30 (approximately) that currently exists. The
business would get back nearer its target by raising the following increment of finance
from the other source. The pattern would probably be something like that depicted
in Figure 10.1. Here the broken line represents the target ratio, with the points A to E
representing consecutive actual financing configurations. The business starts by
raising some initial equity capital (0A) followed by borrowing amount AB, perhaps
through a term loan or an issue of loan notes. It presumably chooses not to raiseFigure 10.1
Graph of the capital
structure of a
geared business
over time
Since there are economies of scale in share and loan notes issue costs, businesses tend not
to raise each tranche of new finance in the same proportion as the target gearing ratio, but
either totally from equities or totally from debt. This means that the actual gearing ratio will
tend to follow a path that wanders from one side of the target to the other. Rarely will the
actual and the target gearing ratios coincide. Points A, B, C, D and E represent actual gearing
at various times, whereas the dotted line represents the target.