BUSF_A01.qxd

Suggested answers to review questions

10.3The level of capital gearing is such an important factor for businesses that it seems

likely that the benefits (tax relief) and costs (potential bankruptcy and so forth)

would be carefully weighed and a target established. Even if this is not always true

for smaller businesses, it seems likely that larger ones will pay attention to estab-

lishing a target.

10.4The reason is that the appropriate discount rate is the opportunity cost of capital for

that particular project, which takes account of the risk involved in the project, and

so forth. There is no reason why the cost of the particular finance just raised should

bear any resemblance to the rate at which the project’s cash flows need to be dis-

counted. The suppliers of the finance will not see that they are specifically financing

the project. They will see themselves as providing part of the finance for the busi-

ness as a whole.

10.5Market values should be used because WACC is meant to represent the opportunity

cost of finance. Market values reflect the cost of any new capital that the business

might raise, or the cost saving achieved by returning some finance to its providers.

10.6No. These are both simplifying assumptions, one of which it is often expedient to

make. Other assumptions could be made. Future dividends are difficult to predict,

so a simple assumption is usually favoured.

11.1There are two main reasons:

lBecause borrowings are the subject of a clear contractual relationship, regard-

ing interest payments and repayment of capital, between the lender and the

business, the risk borne by the loan notes lender is much less than that borne

by the equity holder. Consequently loan notes lenders do not expect such high

returns.

lInterest paid to lenders is deductible for corporation tax purposes; returns to

shareholders are not.

11.2It increases, to reflect the higher level of risk associated with higher gearing.

11.3It increases, to reflect the higher level of risk associated with higher gearing. Taxes

do not really make any difference.

11.4These include costs such as:

lany legal costs that might be involved with winding up the business;

lany losses arising from selling off assets at a lower value than they were worth to

the business as a going concern; and

lany loss of profits involved in trying to keep a sinking business afloat.

11.5We know because, in practice, nearly all businesses raise part, and in many cases a

substantial part, of their total finance from borrowing.

11.6The geared business is worth the same as the ungeared one plus (T×BG), where Tis

the relevant rate of corporation tax and BGis the market value of the borrowings.

12.1The future dividend must be equal to D 0 (1 +k)n, where D 0 is the present dividend, k

is the shareholders’ opportunity cost of finance and nis the number of years into the

future that the dividend will be received.

Chapter 11

Chapter 12

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