The Modigliani and Miller view of gearinginterest). The derivation of the above is shown in Appendix II to this chapter. The term
TBGis often referred to as the tax shieldof borrowings (or debt).
The after-tax proposition implies that the value of the geared business is greater
than the value of the all-equity one; also that the greater the level of gearing, the
greater the value of the business. The inevitable conclusion is that the value is highest
and WACC lowest when gearing is at 100 per cent, that is, when lenders provide all
of the finance.
Figure 11.4 shows the MM after-tax view of capital gearing. There is a contrast with
the pre-tax position depicted in Figure 11.3. In the after-tax case, the cost of borrowing
is low enough (owing to higher tax relief on interest payments) for increasing amounts
of debt finance to reduce WACC at a greater rate than that at which the increasing
demands of equity holders are raising it. Thus the WACC line slopes downwards.
It is doubtful whether this 100 per cent debt finance conclusion is tenable in prac-
tical terms, however. At very high levels of gearing, the lenders would recognise that
their security had been substantially eroded and that, while they might be lenders in
name, as risk takers they are equity holders in reality. They would therefore seek a
level of return that would compensate them for this risk: a level of return similar to
that which the equity holders seek. This would mean that at very high levels of gear-
ing, both in the pre-tax proposition and in the more important after-tax proposition,
the cost of borrowing would rise significantly. For MM’s conclusions to hold, this
requires that the rate of increase in the cost of equity starts to fall. In Figure 11.4, if the
cost of borrowing line is going to start turning upwards at some high level of gearing,‘
Figure 11.4
The cost of capital
for varying levels of
gearing – the MM
(after-tax) view
The logical conclusion of this view is that there is an optimum level of gearing, and that this is
located at 100% gearing. This arises from the assumption that the cost of equity rises at a
rate that would precisely cancel the advantage of the low-cost debt finance at all levels of
gearing, were it not for the fact that the interest on borrowings is tax deductible. The fact that
interest is tax deductible means that the greater the amount of borrowing, the greater the tax
benefit to the business.