Evidence on gearinga shareholder wealth maximisation objective, they are presumably using gearing to
promote that objective. Rightly or wrongly, therefore, managements seem to be-
lieve that gearing lowers WACC.
l Very high levels of gearing are rarely seen. Managements seem not to believe that
the value of the business is maximised (WACC minimised) by very high gearing
levels.Some businesses make public comments about the benefits of financial gearing. The
drinks and confectionery business Cadbury Schweppes plcsaid in its 2006 annual
report: ‘We continue to proactively manage our capital structure to maximise share-
holder value whilst maintaining flexibility to take advantage of opportunities which
arise to grow its business.’Some formal evidence
The questions to which the answers are of real interest are:l Does WACC change with gearing as MM (after-tax) suggested?
l Does it move to a minimum at some level of gearing of less than 100 per cent and
then increase as gearing is further increased?
The publication of the MM articles on capital structure was followed by a number
of studies bearing on the above questions.
Modigliani and Miller (1958) themselves took the lead with a study using data
concerning a number of oil and of electrical utility businesses, and came to the con-
clusion that WACC is not dependent on the level of gearing (supporting their pre-tax
proposition).
Weston (1963) criticised the MM results on the basis that they had made too many
simplifying assumptions. Weston himself used data on electrical utility businesses
to show that the MM after-tax proposition was valid in that WACC seemed to de-
crease with increased gearing. Miller and Modigliani (1966) returned to the scene and,
again using the electrical utilities, they too found evidence to support the after-tax
propositions.
Hamada (1972) found that the cost of equity increases with the level of gearing.
Masulis (1980) found that announcements of a business’s intention to increase the
level of gearing tend to be associated with increases in the price of its equity, and that
announcements of intentions to reduce gearing tend to have an adverse effect on the
equity values. This clearly supports the MM after-tax proposition. It also implies that,
if there is an optimal level of gearing, investors tend to believe that businesses are
operating below it.
DeAngelo and Masulis (1980) found an increase in the value of the business as gear-
ing increases up to a certain point, and a reduction as more debt is added. This was
ascribed to the fact that the tax advantages can become decreasingly valuable with
higher gearing since the business may not have sufficient taxable operating profits
against which to set the interest expense: in other words, the tax deductibility of inter-
est becomes irrelevant. Barclay, Smith and Watts (1995) found, based on US data, that
the tax deductibility of interest is a factor in the levels of gearing, but not a very
significant one.
Homaifar, Zeitz and Benkato (1994) found evidence based on US data that the level
of gearing tends to be higher with businesses exposed to higher corporate tax rates: in