After studying this chapter you will be able to understand: Gearing, financial risk and the cost of capital, traditional theory, modigliani and miller’s theory. | Investment Analysis Lecture: 21 Course Code: MBF702 Outline RECAP GEARING FINANCIAL RISK AND THE COST OF CAPITAL TRADITIONAL THEORY MODIGLIANI AND MILLER’S THEORY Gearing effect Recap Gearing Effect - Recap Gearing effect - Recap There are two main schools of thought Traditional view Modigliani and Miller’s theory TRADITIONAL THEORY As per the traditional theory, till a certain point, if we keep on introducing debt, Kd = fairly constant Ke = increase marginally WACC = keep on decreasing Subsequently; Ke = increase sharply Kd = increases WACC = starts increasing Kd remains constant as gearing level rises upto a level after which it increases Ke rises as gearing level TRADITIONAL THEORY Initially as the gearing level rises, WACC falls due to cheaper debt (KD is always lower than Ke). However if it continues to increase the increase in Ke would become insignificant & WACC should start increasing Conclusion: with change in D/E ratio, WACC changes, therefore, WACC is not equal to the . | Investment Analysis Lecture: 21 Course Code: MBF702 Outline RECAP GEARING FINANCIAL RISK AND THE COST OF CAPITAL TRADITIONAL THEORY MODIGLIANI AND MILLER’S THEORY Gearing effect Recap Gearing Effect - Recap Gearing effect - Recap There are two main schools of thought Traditional view Modigliani and Miller’s theory TRADITIONAL THEORY As per the traditional theory, till a certain point, if we keep on introducing debt, Kd = fairly constant Ke = increase marginally WACC = keep on decreasing Subsequently; Ke = increase sharply Kd = increases WACC = starts increasing Kd remains constant as gearing level rises upto a level after which it increases Ke rises as gearing level TRADITIONAL THEORY Initially as the gearing level rises, WACC falls due to cheaper debt (KD is always lower than Ke). However if it continues to increase the increase in Ke would become insignificant & WACC should start increasing Conclusion: with change in D/E ratio, WACC changes, therefore, WACC is not equal to the marginal cost of capital and consequently can’t be the required rate of return for any new project. However, NPV can be calculated by incorporating DEBT cash flows in the normal cash flows and the discounting the net cash flows . the residual cash flows available to the equity holder of the company, using Ke. TRADITIONAL VIEW OF CAPITAL STRUCTURE - Reasoning The traditional view has no theoretical foundation – often described as the “intuitive approach”. It is believed that Ke rises only slowly at low levels of gearing and therefore the benefit of using lower cost debt finance outweighs the rising Ke. At higher levels of gearing the increased financial risk outweighs this benefit and WACC rises. TRADITIONAL VIEW OF CAPITAL STRUCTURE - Reasoning At higher levels of gearing the increased financial risk outweighs this benefit and WACC rises. Conclusion There is an optimal gearing level (minimum WACC). No method of calculating Ke or WACC or indeed the optimal capital structure. The .
