BUSF_A01.qxd

The traditional view

11.4 The traditional view

The traditional view seems to be that if the expected rate of return from equity invest-

ment in yacht chartering is 14 per cent, this will not be greatly affected by the intro-

duction of capital gearing, at least not up to moderate levels. This view of the effect of

gearing on capital market expectations of returns from equities, loans and WACC is

depicted in Figure 11.2.

Figure 11.2 shows that, as gearing is increased, both equity investors and lenders

perceive additional risk and require higher returns. At lower levels of gearing, how-

ever, neither group requires greatly increased returns to compensate for this risk, and

so WACC reduces. When gearing reaches higher levels, the risk issue becomes increas-

ingly important to both groups, so required returns start to increase dramatically.

Now WACC starts to rise steeply. Although the point at which each group’s required

return starts this steep rise is not necessarily the same, there is a point (or a range

of points) where, according to traditionalists, WACC is at a minimum. This is the

optimum level of gearingin Figure 11.2. At this point the shareholders’ wealth is max-

imised, that is, the price per share would be at its peak. Note that a graph of share price

against the level of gearing would resemble an inversion of the WACC (k 0 ) curve in

Figure 11.2. This means that the share price, and with it, shareholders’ wealth and the

value of the business, would be maximised at the optimum level of gearing.

The rationale for the traditional view seems to be that lenders would recognise that,

at high levels of gearing, their security is substantially lost and would begin to

demand successively higher levels of interest to compensate them for the higher risk

involved. At the same time, up to a certain level of gearing, equity shareholders would

Figure 11.2
The cost of capital
for varying levels
of gearing – the
traditional view

The logical conclusion of this view is that there is an optimum level of gearing, where there is

a minimum weighted average cost of capital. This arises from the assumption that the cost of

equity does not increase sufficiently to outweigh the advantage of the low-cost debt finance

until some significant level of gearing is achieved.