Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
not see the increased risk to their returns as too significant. After that point, however,
they would start to demand major increases in returns for further increases in gearing.
Broadly, the traditional conclusion was that gearing is a good thing, in terms of
shareholder wealth maximisation, at least up to a certain level, past which it would
start to have an adverse effect on WACC and therefore on shareholder wealth.
During the 1950s some observers started to question the value of gearing, finding it
difficult to reconcile the ‘something for nothing’ aspect of the traditional view with the
rapidly growing belief that securities are efficiently and rationally priced.11.5 The Modigliani and Miller view of gearing
In 1958, Modigliani and Miller (MM) published an article, now almost legendary,
questioning the traditional approach to the issue of gearing. MM argued that, given
rational pricing in the capital markets, it is not possible for a business to increase its
total market value (lower its WACC) merely by doing what it is in theory open to any
of us to do: borrow money. They asserted that if a particular business is expected to
generate some level of income, this should be valued without regard to how the busi-
ness is financed.To see how the MM assertion would work in the case of La Mer, let us assume that the
business raised the £1 million for the second vessel by issuing 10 per cent loan notes (that is,
borrowing at 10 per cent p.a.). Let us also assume that there is another business, Sea plc,
identical in every respect to La Mer, but completely financed by 2 million ordinary shares of
£1 each.
Franco, a holder of 1 per cent of the equity of La Mer (that is, 10,000 shares), would
expect a return on them of £1,800 p.a. since, as we have seen, each one is expected to yield
18p p.a. Franco could equally well obtain the same expected income by selling the shares
for £10,000, borrowing an amount equivalent to 1 per cent of La Mer’s borrowings (that is,
£10,000) at the rate of 10 per cent p.a. and using this total of £20,000 to purchase 1 per cent
of the ordinary shares in Sea (20,000 shares). The Sea shares would be expected to yield
14p each and so £2,800 in total, which, after paying interest on the borrowing, would
leave £1,800 p.a. of expected income of risk (business and financial) equal to that of the
expected income from La Mer. Franco’s situation may be restated and summarised as
follows:Investment Income
££
Present position
10,000 shares in La Mer
(i.e. 1% of total shares) 10,000 1,800
Alternative position
Borrow £10,000 (10,000) (1,000)
Buy 20,000 shares in Sea
(i.e. 1% of total shares) 20,000 2,800
10,000 1,800Example 11.2