F9-11 Weighted Average Cost of Capital and Gearing

Session 11
Weighted Average Cost

of Capital and Gearing
FOCUS
This session covers the following content from the ACCA Study Guide.
E. Business Finance
3. Sources of finance and their relative costs
c) Identify and discuss the problem of high levels of gearing.
d) Assess the impact of sources of finance on financial position and financial
risk using appropriate measures including:
ii) cash flow forecasting
2. Estimating the cost of capital
c) Estimating the overall cost of capital including:
i) Distinguising between average and marginal cost of capital.
ii) Calculating the weighted average cost of capital (WACC) using book
value and market value weightings.
3. Sources of finance and their relative costs
e) Impact of cost of capital on investments including:
i) the relationship between company value and cost of capital
ii) the circumstances under which WACC can be used in investment
appraisal
4. Capital structure theories and practical considerations
a) Describe the traditional view of capital structure and its assumptions.
b) Describe the views of Miller and Modigliani on capital structure, both
without and with corporate taxation, and their assumptions.
c) Identify a range of capital market imperfections and describe their impact
on the views of Miller and Modigliani on capital structure.
d) Explain the relevance of pecking order theory to the selection of sources of
finance.
Session 11 Guidance
Understand that WACC is the mix of the cost of equity and post-tax cost of debt, with market value
weighted being preferred to book value weighting (s.1.1). Attempt Examples 1 and 2 learn WACC's
limitations (s.1.2).
Read section 1.3 on the marginal cost of capital (MCC). Be sure to know why the MCC should not be
used as a discount rate for a project.
Understand the effect of financial gearing on WACC (s.2.1), the problems of high financial gearing
(s.2.2) and how to prepare cash flow projections (s.2.3). Work through Example 3.
(continued on next page)
F9 Financial Management Becker Professional Education | ACCA Study System
Ali Niaz - ali.niaz777@gmail.com

VISUAL OVERVIEW
Objective: To understand weighted average cost of capital (WACC), including how it is
estimated and the effect of gearing on it; the traditional view of capital structure; Modigliani
and Miller's models; and pecking order theory.
WEIGHTED AVERAGE
COST OF CAPITAL
Calculation of WACC
Limitations of WACC
Marginal Cost of Capital
FINANCIAL GEARING
Effect
High Financial Gearing
Forecasting Cash Flows
CAPITAL STRUCTURE
TRADITIONAL VIEW MODIGLIANI AND INFLUENCES

MILLER'S THEORIES
Reasoning Practical Factors
Introduction
Conclusions Research
Theory Without Tax
Project Finance
Theory With Tax
Approach
Session 11 Guidance
Go through the theories of how financial gearing affects a firm's capital structure and WACC
(s.3, s.4). Be sure to know the conclusions of each theory.
Read what other influences/factors affect a firm's capital structure decisions and understand the
implications of the pecking order theory (s.5).
Read the article "Optimum Capital Structure".
2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-1

Session 11 Weighted Average Cost of Capital and Gearing F9 Financial Management
1 Weighted Average Cost of Capital (WACC)
1.1 Calculation
Companies are usually financed by both debt and equity (i.e.
they use some degree of financial/capital gearing). The weighted
average cost of capital (WACC) represents a company's average
cost of long-term finance.
In the exam the formula given is:
Ve Vd
WACC = ke + k d (1 T )
V
e + Vd Ve + Vd
where:
Ve = Total market value of equity
Vd = Total market value of debt
ke = Cost of equity geared
kd =
Pre-tax cost of debt
T = Corporation tax rate
For a redeemable bond, the IRR of its post-tax cash flows

must be calculated to find the post-tax cost of debt.
For irredeemable debentures or bank loans, the post-tax cost
of debt = kd(1 T).
Market values of equity/debt (where available) are used to
weight the individual costs of capital.
If the firm's shares are not listed on the stock market,
however, then the book value of equity will have to be used.
Similarly for debt (i.e. if the firm has issued bonds then use
the market value but for bank loans the book values would
have to be used).
11-2 2014 DeVry/Becker Educational Development Corp. All rights reserved.

F9 Financial Management Session 11 Weighted Average Cost of Capital and Gearing
WACC is a potential discount rate for project appraisal using NPV.
Current WACC is used as the discount rate only if:
Proportion of
debt to equity
does not change.
Project is financed Project has same business

by existing pool of funds. risk as existing operations.
So, a company's existing WACC can be used as the discount rate

for a potential project only if that project does not change the
company's:
gearing level (i.e. financial risk); or
business risk.
Example 1 WACC
A company has in issue:

45 million $1 ordinary shares
10% irredeemable bond with a book value of $55 million
The bond is trading at par.
Share price $1.50

Dividend 15c (just paid)
Dividend growth 5% p.a.
Corporation tax 33%
Required:
Estimate the WACC
Solution
WACC =

Example 2 WACC Using Book Values
Lifestyle Co is a family-owned company whose shares are not listed on the stock market.
However, the family members have stated that they require an annual return of 12% to
compensate for the risk of their shareholdings.
The following is a summary of the most recent statement of financial position:
$m $m
Assets
Non-current assets 300
Current assets 211
Total assets 511
Equity and liabilities
Share capital 100
Retained earnings 121
Total equity 221
Non-current liabilities
Long-term borrowings 200
Current liabilities
Trade payables 80
Accruals 10
Total current liabilities 90
Total liabilities 290
Total equity and liabilities 511
Additional information
Non-current assets include significant property acquired many years ago which has been
recorded at historical cost.
The long-term borrowings consist of a bank loan at an annual interest rate of 8%.
The company pays 25% tax on its profits.
Required:
(a) Estimate Lifestyle Co's weighted average cost of capital (WACC).
(b) Give FOUR reasons why it would be preferable to use market values rather than
book values when estimating the WACC and suggest ONE improvement that
Lifestyle could make to its estimate.
Solution
(a) WACC
(b) Market value

Why preferable
1.
2.
3.
4.
One Improvement

1.2 Limitations
LIMITATIONS
PRACTICAL
THEORETICAL
Assumes perfect capital market
Assumes that
CALCULATION OF ke
market value of shares
= PV of dividend stream Estimation of g
market value of debt historical data used to
= PV of interest/principal estimate future growth rates
Current WACC can only be used Gordons growth
to assess projects which: approximation assumes all
have similar operating risk to growth is financed by retained
that of the company earnings
are financed by the companys Share price may not be in

pool of funds, i.e. have same equilibrium
financial risk Ignores personal taxation
Assumes constant growth
CALCULATION OF kd
Assumes constant tax rates
Bond price may not be in
equilibrium
Difficulty in incorporating all
forms of long-term finance, e.g.
BANK OVERDRAFT CONVERTIBLE DEBT FOREIGN LOANS

Current liability but often Uncertain final cash flow Exchange rates will affect
has permanent core Investor has option of the value of the loans
to be included and the
Must be split between (i) taking the redemption interest payments
fixed and variable value, or
element (ii) converting into shares
Put fixed element in Assume it will be
calculation redeemed unless data
is available to suggest
conversion

1.3 Marginal Cost of Capital

Marginal cost of capital (MCC) is the cost of raising the most
recent dollar of finance.
At first, it may seem reasonable to use MCC as the discount
rate for project appraisal. But this can lead to problems:
project finance may be drawn from the firm's pool of funds
and not from a specific source;
even if a project is financed from a specific source it may
not be appropriate to evaluate it using the MCC. For
example, if a project is financed by debt the discount rate
for NPV should not be the cost of debt as this ignores
the fact that the surplus cash flows belong to the equity
investors and are exposed to business risk. Hence, the
cost of debt understates the risk of the project and would
lead to an overstatement of the project's NPV.
Therefore, the WACC is a more appropriate discount rate than
the MCC, as the WACC is an average of the cost of equity
(which measures business risk) and the cost of debt.
2 Financial Gearing
2.1 Effect
The current WACC reflects the current risk profile of the company:
both business risk and financial risk.
Business riskthe
As a company gears up, two things happen: variability in the
operating earnings of
the company (i.e. the
WACC = keE + kd D
volatility of EBIT due
E+D to the nature of the
industry).
Financial riskthe
additional variability
ke increases due The proportion of in the return to
debt relative to equity as a result
to the increased
equity in the capital of introducing debt
financial risk. (i.e. using financial
structure increases.
All else equal, this gearing). Interest on
pushes up the value Since kd < ke this debt is a committed
of WACC. pushes the value of fixed cost which
WACC down, all else creates more volatile
equal. bottom-line profits for
shareholders.
The effect of increased gearing on the WACC depends on the

relative sizes of these two opposing effects.
There are two main schools of thought with respect to gearing:
1. Traditional view (see s.3).
2. Modigliani and Miller's theories (see s.4).

2.2 High Financial Gearing

A firm's level of financial gearing may be considered relatively
high when its debt to equity ratio is significantly above the
industry average and/or its interest coverage ratio (EBIT divided
by interest expense) is relatively low.
Potential problems of high levels of financial gearing include:
< High level of financial risk: The high level of debt will create
high levels of committed interest expense and hence more
volatile earnings to equity investors, thereby pushing up the
cost of equity.
< Financial distress costs: The firm may lose customers due
to concerns about its survival (particularly if it sells durable
goods with a warranty) and may lose key staff if employees
become concerned about job security.
< Increased credit risk: The ratings agencies may cut the firm's
credit rating, pushing up its cost of debt.
< Agency costs: Debt contracts would include increasingly
restrictive covenants (e.g. limiting dividend payments or
forcing the firm to stay within low-risk projects). In this way
the directors become agents of debt holders rather than of
the equity investors and shareholder returns are subsequently
damaged.
2.3 Forecasting Cash Flows

To survive, all businesses must maintain an uninterrupted
capacity to pay debts when they fall due. As debts are normally
paid in the form of cash, the cash flows of a business should be a
matter of intense interest to its managers.
A forecast cash flow statement helps managers to monitor future
movements in cash. It sets out the anticipated cash inflows
and outflows arising over a particular forecast period and so can
provide an early warning of problems. For example, a forecast
cash flow statement may help to identify future breaches of an
overdraft limit which has been agreed with the bank and this may
allow managers time to review their plans.
Where the forecast cash flow statement indicates a cash surplus,
managers have the opportunity to consider whether this surplus
should be reinvested, used to make early redemptions of debt or
distributed to shareholders.

Example 3 Cash Flow Forecast
Victor is a clothing wholesaler. At the beginning of June, it has a bank overdraft of $75,000.
The overdraft limit agreed with the bank is $90,000 and management is keen to keep within
this. The overdraft has grown significantly over the past three months and, to avoid exceeding
the limit, management is reviewing its plans for the next six months.
The following actual and forecast information for the period April to November is available:
Actual Forecast
April May June July August Sept Oct Nov
$000 $000 $000 $000 $000 $000 $000 $000
Sales 285 270 280 340 320 275 260 285
Purchases 188 164 175 204 183 188 167 194
Administration expenses 42 38 45 48 42 45 42 39
Selling expenses 36 74 45 43 47 42 46 48
Taxation payment 29
Mortgage repayment 70
Capital expenditure 38 59
Notes:
(1) All sales are on credit. Customers paying within one month receive a 2% discount for
prompt payment.
(2) 80% of credit customers pay within one month and 20% of customers pay two months
after the sale.
(3) Suppliers allow one month's credit.
(4) Management has negotiated an early repayment of a mortgage on freehold property.
The outstanding capital sum is due to be repaid in August.
(5) Administration expenses are paid when incurred and include a monthly depreciation
charge of $12,000.
(6) Selling expenses are payable one month after they are incurred.
Required:
(a) Prepare a forecast cash flow statement for internal purposes for Victor for the
six months ended 30 November which shows the cash balance at the end of
each month.
(b) Comment on the information provided by the forecast cash flow statement
provided in (a) above and suggest how the directors might deal with any
problems which are revealed.

Example 3 Cash Flow Forecast (continued)
Solution
(a) Cash flow forecast for the six months to 30 November
June July August Sept Oct Nov
$000 $000 $000 $000 $000 $000
Receipts
Sales
-within 1 month
-within 2 months
Total Receipts
Payments
Purchases
Administration expenses
Selling expenses
Taxation due
Mortgage repayment
Capital expenditure
Total Payments
Net cash flow
Opening balance
Closing balance
(b) Comment

3 Traditional View of Capital Structure
3.1 Reasoning
The traditional view has no theoretical foundation; it is often
described as the "intuitive approach". It is based on the trade-off
caused by gearing (i.e. using more, relatively cheap, debt results
in a rising cost of equity). This model/view assumes that the
following occurs:
ke rises slowly at low levels of gearing and, therefore, the
benefit of using lower-cost debt finance outweighs the cost of
the rising ke.
At higher levels of gearing, the increased financial risk
outweighs this benefit and WACC rises.
At very high levels of gearing, the cost of debt rises. This is
due to the risk of default on debt payments (i.e. credit risk).
This is referred to as financial distress risk; it should not be
confused with financial risk, which occurs even at relatively
safe levels of debt.
These relationships are shown in the graph below:
Cost of
capital ke
%
WACC
kd
D/E
Optimal
gearing
Value
of firm
$
Vu
Vg
D/E
Optimal
gearing *Value of geared firm
= Value of equity +
Value of debt.
Vu = value of ungeared firm, Vg = value of geared firm*

3.2 Conclusions
As the graph shows, there is an optimal gearing level (an optimal
capital structure) at which WACC is minimised and hence the
NPV of all projects is maximised (i.e. the value of the firm is
maximised).
However, there is no straightforward method of calculating ke
or WACC, much less the optimal capital structure.
The optimal capital structure can only be found by trial and
error.
3.3 Project FinanceImplications

With respect to the optimal gearing level, the company needs to
determine whether or not it is optimally geared.
If it is optimally geared: finance should be raised so as to
maintain the existing gearing ratio.
If suboptimally geared: raise debt finance so as to increase
the gearing ratio towards the optimal level.
If supraoptimally geared: raise equity finance so as to reduce
the gearing ratio back to the optimal level.
3.4 Approach
Appraise the project at the existing WACC:
If
the NPV of the project is positive the project is
worthwhile.
Appraise the finance:
If marginal cost of the finance > WACC the finance is not
appropriate and should be rejected.
If this was the case the company could raise finance in the
existing gearing ratio and the WACC would not rise.

4 Modigliani and Miller's Theories
4.1 Introduction
Modigliani and Miller (MM) constructed a mathematical model
to provide a basis for company managers to make financing
decisions.
Mathematical models predict outcomes which would occur
based on simplifying assumptions.
Comparison of the model's conclusions to real-world
observations then allows researchers to understand the effect
of the simplifying assumptions. By relaxing these assumptions
the model can be moved towards real life.
MM's assumptions include:
Investors are rational.
Capital markets are perfect.
There is no tax (either corporate or personal). But this
assumption is later relaxed.
Investors are indifferent between personal and corporate
borrowing.
There is no financial distress risk (i.e. no risk of default even
at very high levels of debt).
There is a single risk-free rate of borrowing (Rf).
Corporate debt is irredeemable.
4.2 Theory Without Tax
MM considered two companies, both the same size and with
the same level of business risk:
1. One company, U, was ungeared.
2. One company, G, was geared.
MM's basic theory was that in the absence of corporation tax,
the market values (V) and, hence, the WACC's of these two
companies would be the same.
Vg = Vu
WACCg = WCCu
MM argued that the individual costs of capital would change as

gearing changed in the following manner:
k would increase at a constant rate as gearing increased
e
due to the perceived increased financial risk.
k would remain constant (at R ) whatever the level of
d f
gearing because there is no financial distress risk.
The rising k exactly offsets the benefit of cheaper debt in
e
order for the WACC to remain constant.

This can be shown as a graph:
Cost of
capital
ke
WACC
kd
D/E
Value
of firm
Vg
Vu
D/E
The model's conclusions are:

There is no optimal gearing level.
The value of the company is independent of the financing
decision.
Only investment decisions affect the value of the company.
These conclusions fail in practice because the assumptions are

too simplistic. There are differences between the real world
and the model.
MM never claimed that gearing does not matter in the real
world. They said that it would not matter in a world in which
their assumptions hold. They were then in a position to relax
the assumptions to see how the model's predictions would
change.

4.3 Theory With Tax

The first assumption they relaxed was regarding corporate tax.
When MM took corporation tax into consideration, their
conclusions regarding capital structure were altered. This
is because of the tax relief available (the tax shield) on debt
interest.
When corporation tax is introduced, MM argue that the
individual costs of capital will change as follows:
k increases as gearing levels increase to reflect additional
e
perceived financial risk.
k is now the post-tax cost of debt (i.e. R [1 tax rate]).
d f
As gearing increases there is upward pressure as the result
of the rising cost of equity, but there is even stronger
downward pressure due to the very low after-tax cost of debt.
Overall, the WACC falls.
This can be shown as a graph:
Cost of ke
capital
WACC
kd
D/E
$ Vg
Value
of firm
Vu
D/E

The model's conclusions are:

There is an optimal gearing level and that level is at 99.99%
debt in the capital structure.
This implies that the financing decision for a company is
vital to its overall market value and that companies should
gear up as far as possible.
These conclusions fail in practice for the following reasons:
At high levels of gearing the risk of default on debt becomes
significant (i.e. the cost of debt rises).
Personal taxes exist and these may cause investors to
prefer injecting equity rather than debt if dividends are
taxed at lower rates than interest income.
Thus, MM's theories show that in practice there are many
factors which a company will need to consider in deciding its
level of financial gearing.

5 Influences on Capital Structure
5.1 Practical Factors

The following factors should be considered:
The project's business risk. It is not wise to finance high-risk
projects with debt, as payment of interest is a legally binding
commitment.
Existing level of financial gearing.
Existing level of operational gearing, which is the proportion
of fixed to variable operating costs. If this is high, then the
company may not wish to use debt as this increases the level
of fixed costs even further.
Quality of assets available for security on debt.
Personal tax position of the shareholders and debtholders.
Market sentiment (e.g. frozen debt markets following the 2007
US sub-prime meltdown).
Tax exhaustion (not enough profit to fully utilise the interest
tax shield).
Issue costs.
Agency costs. At high levels of financial gearing, the control
of the firm may move away from the shareholders towards
the debt investors (e.g. restrictive debt covenants may restrict
dividends or limit operations to low-risk areas).*
*Limiting operations
Costs of financial distress. At dangerous levels of financial to low-risk areas may
gearing, the firm may find that its costs of doing business reduce returns to
start to rise (e.g. suppliers may ask for payment in advance, shareholders.
staff turnover may rise, customers may lose faith in the
warranties on the firm's products).

5.2 Research Findings

As was discussed in Session 8, company managers usually
prefer to use internal finance rather than external finance. This
preference for internal finance is known as the pecking order
theory and is supported by research which found that company
directors often choose "the path of least resistance" (i.e. the most
convenient source) when it comes to financing a project.
Research has shown that the following hierarchy emerges:
Internal finance (i.e. reinvestment of profit) is preferred
to raising external finance. There are several practical
advantages of using internal finance:
management time is not consumed by paperwork;
no issue costs;
no change in the firm's control structure;
privacy (e.g. no need to publish a prospectus); and/or
external finance may not be available, particularly for
SMEs due to asymmetry of information (a perceived
high risk due to a lack of public information about the
business).
If internal finance is not sufficient, perhaps because existing
shareholders require a significant dividend, then external
finance must be raised. Here the preference is for debt
because:
debt is cheaper than equity;
interest is tax allowable, which results in a tax shield;
issue costs are lower on debt than equity; and/or
debt can be raised more quickly than equity.
If debt cannot be raised (e.g. due to lack of assets for
security), then a share issue is inevitable. A new share issue
ranks last in pecking order theory because:
the cost of equity is high because equity investors are
exposed to high risk (business and operating risk);
dividends do not give the firm a tax shield;
issue costs are high (e.g. 6% to 11% in the case of an
initial public offering (IPO) in the UK); and/or
share issues take much time and effort to organise.

Summary
WACC estimates the company's average cost of long-term finance.
WACC is a potential discount rate to use for the calculation of the NPV of possible projects.
However, the existing WACC should only be used if the project would not change the
company's business risk or level of gearing (i.e. financial risk).
WACC's limitations and practical problems include:
its assumption of perfect capital markets;
incorrect calculations of the cost of equity because of dependency on growth estimates,
share prices may not be in equilibrium etc; and
incorrect calculations of the cost of debt because it assumes constant tax rates, bond
markets are in equilibrium etc.
MCC should not be used as the discount rate for project appraisal because:
a project's nance may be drawn from the rm's pool of funds and not from a specic
source; and
it can ignore business risk.
There are various and conflicting models of how financial gearing affects the WACC. The
models include the following: traditional trade-off theory, Modigliani and Miller (MM) without
tax and MM with corporate tax. Each model has useful elements, even if the conclusions of
such models lack practical relevance.
Per the traditional trade-off theory, there is an optimal gearing level (an optimal capital
structure) at which WACC is minimised and hence the NPV of all projects is maximised (i.e.
the value of the firm is maximised).
MM without tax concludes: (1) there is no optimal capital structure and (2) a company's
value is only affected by its investment decisions and is not affected by how it is financed.
MM with tax concludes that a firm should use as much debt financing as possible if it wants
to maximise its overall market value.
Under the pecking order theory, managers choose the path of least resistance (e.g. the
most convenient source) of financing for a project.

Session 11
Session 11 Quiz
Estimated time: 20 minutes
1. State whether market or book values should be used in the estimate of WACC. (1.1)
2. State the conditions when a company's existing WACC can be used as the discount rate
for a potential project. (1.1)
3. Define marginal cost of capital. (1.3)
4. Define business risk and financial risk. (2.1)
5. Explain the effect of gearing on WACC according to the traditional view. (3)
6. Explain the effect of gearing on WACC according to the Modigliani and Miller model
without tax. (4.2)
7. Explain the effect of gearing on WACC according to the Modigliani and Miller model
with tax. (4.3)
8. State the preferred source of finance under pecking order theory. (5.2)
Study Question Bank

Estimated time: 1 hour 10 minutes
Priority Estimated Time Completed
MCQs - Session 11 30 minutes
Q22 Redskins 40 minutes

Additional
Q23 Berlan

EXAMPLE SOLUTIONS
Solution 1WACC
D0(1 + g)
ke = +g
P0
$0.15 (1 + 0.05)
= + 0.05 = 15.5%
$1.50
kd = 10% (pre-tax) (1 0.33) = 6.67% (after-tax)
E D
WACC=k e +k d
E+D E+D
45m $1.50 $55m
0.155 + 0.067
( 45m $1.50 ) + $55m ( 45m $1.50 ) + $55m

WACC = 11.55%
Solution 2WACC Using Book Values

(a) WACC
As market values are not available book values have to be used as the
weightings in the WACC:
Ve Vd
WACC = Ke + Kd (1 T )
V
e + Vd Ve + Vd
221 200
=
221 + 200 12% + 221 + 200 8% (1 0.25) = 9.15%

(b) Market value

Why preferable
Although the market value of debt is often reasonably close to its
book value (and in any case bank loans are not traded on a secondary
market), the market value of equity is often significantly above the net
assets as shown on the statement of financial position. In such cases it
would be preferable to weight the cost of equity using the market value
of equity because:
1. the book value of equity is subjective as it depends on accounting
policies such as depreciation;
2. the book value of equity fails to capture the value of significant
intangible assets such as internally-generated goodwill;
3. the book value of equity is out of date due to the delay in publishing
financial statements; and
4. weighting using the book value of equity will tend to understate the
influence of the cost of equity, thereby understating the WACC, which
could lead to incorrect investment decisions.
One Improvement
The company has significant property, which is currently recorded at
historic cost. It may be advisable to restate this to market value (as
permitted under IFRS), thereby creating a revaluation surplus within the
equity section of the statement of financial position and moving the book
value of equity closer to its market value.

Solution 3Cash Flow Forecast
(a) Cash flow forecast for the six months to 30 November
June July August Sept Oct Nov

$000 $000 $000 $000 $000 $000
Receipts
Sales
within 1 month 212 220 267 251 216 204
within 2 months 57 54 56 68 64 55
Total Receipts 269 274 323 319 280 259
Payments
Purchases 164 175 204 183 188 167
Administration expenses 33 36 30 33 30 27
Selling expenses 74 45 43 47 42 46
Taxation due 29
Mortgage repayment 70
Capital expenditure 38 59
Total Payments 271 285 385 322 260 240
Net cash flow (2) (11) (62) (3) 20 19
Opening balance (75) (77) (88) (150) (153) (133)
Closing balance (77) (88) (150) (153) (133) (114)
(b) Comment
The cash flow forecast indicates that the company will breach the overdraft limit agreed with
the bank from August onwards. Although the size of the overdraft decreases in October and
again in November, it will remain significantly above the agreed limit. Some revision of earlier
plans is necessary. A number of possible ways to improve cash flows may be considered.
These may include:
an injection of long-term capital, such as ordinary shares or debt;
delaying capital expenditures (assuming no binding commitments have been made);
postponing the early mortgage repayment;
chasing receivables that pay after two months rather than after one month;
delaying payments to suppliers.
The business should be aware of the risk that the last two suggestions will have adverse
repercussions for the company.
Although there may be cost savings, the forecast overdraft during the six-month period exceeds
the agreed limit by a significant amount and it is unlikely that cost savings alone would be
sufficient to deal with the problem.

F9-11 Weighted Average Cost of Capital and Gearing

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F9-11 Weighted Average Cost of Capital and Gearing

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Session 11

Weighted Average Cost

Ali Niaz - ali.niaz777@gmail.com

TRADITIONAL VIEW MODIGLIANI AND INFLUENCES

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1 Weighted Average Cost of Capital (WACC)

For a redeemable bond, the IRR of its post-tax cash flows

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WACC is a potential discount rate for project appraisal using NPV.

Current WACC is used as the discount rate only if:

Project is financed Project has same business

So, a company's existing WACC can be used as the discount rate

A company has in issue:

Share price $1.50

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Example 2 WACC Using Book Values

(b) Market value

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are financed by the companys Share price may not be in

BANK OVERDRAFT CONVERTIBLE DEBT FOREIGN LOANS

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1.3 Marginal Cost of Capital

The effect of increased gearing on the WACC depends on the

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2.2 High Financial Gearing

2.3 Forecasting Cash Flows

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Example 3 Cash Flow Forecast

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Example 3 Cash Flow Forecast (continued)

Net cash flow

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3 Traditional View of Capital Structure

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3.3 Project FinanceImplications

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4 Modigliani and Miller's Theories

MM argued that the individual costs of capital would change as

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This can be shown as a graph:

The model's conclusions are:

These conclusions fail in practice because the assumptions are

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4.3 Theory With Tax

This can be shown as a graph:

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The model's conclusions are:

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5 Influences on Capital Structure