BUSF_A01.qxd

Chapter 11 • Gearing, the cost of capital and shareholders’ wealth

and more generally,

VU=VG

where VUand VGare the total value of the ungeared and geared businesses respectively.

The implication of the MM proposition is that the value of the business is not

affected by the financing method (that is, VU=VG): therefore the cost of capital is not

reduced (or affected at all) by the introduction of gearing. The only matters on which

the value of the business and its WACC depend are:

l the cash flows that the business’s investments are expected to generate; and

l their risk (that is, their business risk).

This is another phenomenon following the same pattern as Fisher separation (see

Chapter 2). MM were, in effect, saying that management should concentrate all its

efforts on finding and managing investment opportunities, leaving the financing

arrangements for individual shareholders to decide for themselves.

The effect suggested by MM is shown graphically in Figure 11.3. Here we can see

that the potential that increasing amounts of cheapdebt finance have for reducing

WACC is exactly offset by the increasing cost of equity. Thus WACC is impervious to

the level of gearing and, therefore, remains constant.

We see from Figure 11.3 that shareholders in geared businesses expect a return

equal to the expected return from the identical ungeared business, plus a premium

that is directly proportional to the level of gearing. Thus, while gearing increases earn-

ings per share, it also increases capital market expectations of the share’s returns

Figure 11.3

13.2 The dynamics of working capital

for varying levels of
gearing – the MM
(pre-tax) view

The logical conclusion of this view is that there is no optimum level of gearing. WACC will

be identical at all levels of gearing. This arises from the assumption that the cost of equity

rises at a rate that precisely cancels the advantage of the low-cost debt finance at all

levels of gearing.