Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
‘The interest rate demanded by lenders remains the same at
all levels of gearing’
At very low levels of gearing the position of lenders is one of great security, with the
value of their loan probably covered many times by the value of the business’s assets.
As gearing increases, this position erodes until at very high levels lenders, because
they provide most of the finance, bear most of the risk.
Going back to Example 11.1 (La Mer), suppose that the unexpanded business
(that is, just one yacht worth £1 million) were financed 90 per cent by equity shares
and 10 per cent by loan notes. Here the value of the yacht would have to fall by 90 per
cent before the security of the lenders would be threatened. Even if the equity/debt
ratio moved to 80/20, the lenders’ security, while in theory slightly weakened, would
not be less in practical terms than had they supplied only 10 per cent of the finance. If,
however, the ratio moved to 10/90, only a small drop (10 per cent) in the value of the
yacht would leave the lenders bearing the risk. Naturally enough, lenders would
demand high returns to induce them to lend to such a highly geared business, pre-
sumably something like the returns expected by equity shareholders.
Logically, the lenders would not see risk (and required return) increasing
significantly with increases in gearing at the lower end. After all, unless the asset on
which security rests is extremely volatile in its value, an asset value/debt ratio of 5/1
is probably as good as 10/1; the lenders need only to be paid once. If this ratio
increased to nearer 1/1, lenders would no doubt start to see things differently.11.11 The trade-off theory
It is notable that neither of the above two ‘weak’ assumptions of MM significantly
affects the position at lower levels of gearing. At higher levels, however, they start to
loom large. In the light of this, and taking account of the evidence that we briefly dis-
cussed, we may perhaps draw a tentative conclusion.
Up to moderate levels of gearing, the tax advantages of borrowing will cause the
WACC to decrease as more gearing is introduced, as MM (after-tax) predicted.
Beyond moderate levels, bankruptcy risk (to equity shareholders) and the introduc-
tion of real risk to lenders will push up the returns required by each group, making
WACC a very high figure at high gearing levels.
Figure 11.5 depicts this conclusion with kE, k 0 and kBall following the same pattern
as shown in Figure 11.4 (MM after-tax) up to a moderate level of gearing and then all
starting to take off to very high levels as further gearing is introduced.
It is more likely that, in real life, ‘moderate’ is not a fixed point for any particular
business; it is, rather, a range below which MM’s proposition holds, but above which
it clearly does not. The key question, then, is what does ‘moderate’ mean? The prob-
lem is that ‘moderate’ is likely to be difficult to define and, as such, a matter of judge-
ment for financial managers. It must be the point at which the balance is struck
between the tax advantage, on the one hand, and bankruptcy cost and rising cost of
borrowing, on the other. This will vary from industry to industry and will to some
extent depend upon the business risk (perhaps measured by beta) of the investments
in which the particular business is engaged.
More formally, the relationship between the value of the geared and ungeared busi-
nesses can be expressed as: