Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
La Mer’s ordinary shareholders will only be better off through the introduction of
gearing if the capital market, when it reassesses the situation, following the loan notes
issue and the purchase of the second yacht, prices the ordinary shares so that their
expected yield is less than 18 per cent.
Before La Mer’s expansion these ordinary shares had an expected yield of 14 per
cent. If, as a result of the higher risk level, after the expansion the market expected a
return of, say, 16 per cent, the price per share would be=£1.125
- that is, an increase in value per share.
If, on the other hand, capital market requirements for the level of risk rose to 20 per
cent, the price per share would become
=£0.90
The key question is, will the introduction of gearing lower the weighted average
cost of capital (WACC) and therefore make the investments in which the business is
involved more valuable, or not?
Given the business’s overall objective of maximisation of shareholder wealth, how
the capital market reacts, in terms of required returns, to the introduction of gearing
is an important matter. Gearing is, presumably, undertaken only with the objective of
increasing equity shareholders’ wealth.£0.18
0.20
£0.18
0.16
Figure 11.1
The return on equity
over time for a
financially geared
business with
fluctuating profits
Financial gearing has the effect of accentuating the fluctuations in the returns to equity
holders. The basic fluctuations are related to business risk. Gearing adds the effect of
financial risk to this.