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Unformatted text preview: MA826 23 Cost of Capital Financing Equity Debt Cost of equity > Cost of debt WACC=Weighted Average Cost of Capital WACC is sensitive to debt/equity ratio Ignoring tax: WACC = w d return required by debt investors + w e return required by equity investors w d = market value of debt/(market value of debt+equity) w e = market value of equity/(market value of debt+equity) Return expected by equity investors is the total return and would be > return on debt. Traditional view Emphasis on gearing ie If debt w d w e so WACC Companies could increase gearing as long as there is no risk of bankruptcy Important assumption : return on equity is unchanged as gearing increases. Miller Modigliani View Gearing is irrelevant as debt cost of equity so WACC remains the same Example Suppose a company has: Market value of debt = 100m GRY on debt = 10% Market value of equity = 100m Annual return on equity expected by investors = 12% WACC = (100/200) 10% + (100/200) 12% = 11% Now suppose company raises an extra 100m of debt Traditional view WACC would fall (How?) MM view WACC would be higher (Why?) Two reasons: 1. Higher equity return: Higher gearing higher risk investors expect higher return eg 13% 2. Lender would ask for higher return eg 10.25% because of higher gearing 200 10.25% + 100 13% WACC = = 11.2% 300 higher WACC An increase in debt will leave the company no better off. CAPM CAPM attempts to explain the relationship between risk and return. Cost of equity Cost of equity = risk free rate + equity risk premium nominal: rate of return on a fixed interest gilt Risk free rate Real: Yield on index Linked gilts Barclay Capital EquityGilt Study estimate equity risk premium = 4% ? CAPM and risk Good deal of variation in return of different...
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 Spring '11
 loba,millet
 Math

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