BUSF_A01.qxd

11.2 Is debt finance as cheap as it seems?

In Chapter 2 we found, subject to several assumptions, that financing through bor-

rowing rather than equity does not seem to make any difference to the wealth of the

shareholders. In this chapter we shall review the traditional view, that capital gearing

does have an effect on shareholders’ wealth, before we go on to develop the point

raised in Chapter 2. After this we shall review the evidence and try to reach some con-

clusion on the matter.

11.2 Is debt finance as cheap as it seems?

It is widely believed that the capital market prices securities so that expected returns

from equities are higher than those from term loans and loan notes. Historically, this

belief has been valid over all but fairly brief periods (see, for example Dimson, Marsh

and Staunton 2002). Does the apparent cheapness of debt finance really mean that

equity holders will benefit from the use of it in the business’s capital structure?

La Mer plc has one asset, a luxury yacht, which is chartered to parties of rich holiday-

makers. Profits of the business over the next few years are expected to be £140,000 p.a. La

Mer is financed entirely by equity, namely 1 million ordinary shares whose current market

value is £1 each. The business pays all of each year’s profit to shareholders as a dividend.

La Mer plc intends to buy an additional, similar vessel, also expected to generate annual

profits of £140,000 p.a., at a cost of £1 million. The finance for this is to be provided by the

issue of £1 million of 10 per cent loan notes. This debt is to be secured on the two vessels.

Without the new yacht, the return per share is expected to be

=£0.14 per share

If the second yacht is acquired, the annual return per share will be:

Profit from chartering (2 ×£140,000) £280,000

Less: Interest (£1 million @ 10%) 100,000

£180,000

• that is:

=£0.18 per share

Thus the expected return is increased by the use of loan notes. (Note that if the finance

for the new yacht had been raised by issuing 1 million ordinary shares of £1 each, the annual

return per share, with the second yacht, would have remained at £0.14.)

£180,000

1,000,000

£140,000

1,000,000

Example 11.1

Since the ordinary shares of La Mer plc are priced at £1 each, when returns are

expected to be 14p per share, we may infer that investors regard 14 per cent as the

appropriate return for such an investment. If the expected returns increase to 18p per

share following acquisition of the second vessel, this seems likely to push up the price

of an ordinary share to £1 ×18p/14p =£1.286 (18p represents a 14 per cent return on