WEIGHTED AVEERAGE COST OF CAPITAL AND GEARING

It is rare to find a company relying solely on one source of funds. The balance sheets of even modest-sized businesses show that companies raise investment funds through a variety of channels. Furthermore, they pay different rates on the various components of their capital structures. The resulting overall cost of capital, is usually referred to as the weighted average cost of capital (WACC). As the term suggests, the WACC is simply the sum of the costs of the individual components of capital where each component is weighted in accordance with its relative importance in the total capital structure.

The WACC is important for two closely inter-linked reasons, Firstly The analysis of the cost of the individual components of capital showed that the cost of capital is pivotal to the relationship between expected future cash flows accruing to a particular capital asset and the market value of the asset. We saw that the market value of a capital asset is the discounted value of the expected future cash flows, with the cost of capital acting as the discount factor. Similarly, a company’s WACC is critical to measuring the relationship between the expected future cash flows and the total market value of the company. And secondly The analysis of the WACC allows us to confront the question of whether changes in the level of gearing can affect the overall cost of capital that a company pays and, by implication, the total market value of the company’s assets. In other words, does there exist an optimal capital structure, where the cost of capital is minimized and the value of the company maximized?

Gearing occurs when a company is financed partly through fixed return finance for instance loans, loan stock & debentures and  finance  For instance  loans, loan stock & debentures) and  partly through equity. Loan financing is a cheap source of finance, It happened because there is low risk to lenders and also because it is tax deductible. According to the traditional view this will be resulted in a lowering of the WACC. Gearing - Modigliani & Miller’s View In 1958 a theory was published by Franco Modigliani and Merton Miller which said that it did not matter whether a company that it did not matter whether a company had a level of gearing of 2% debt or 90% debt, the WACC would remain unaltered.

There are 3 theories about the relationship between WACC and gearing, The first one is conventional theory. In this theory, when there is only equity, the WACC starts at the cost of equity. As the more expensive equity finance is replaced by cheaper debt finance, the WACC decreases. However, as gearing increases further, both debt holders and equity shareholders will perceive more risk, and their required returns both increase. Inevitably, WACC must increase at some point. This theory predicts that there is an optimum gearing ratio at which WACC is minimized. The second one is Modigliani and Miller (M&M) without tax, in this theory M&M were able to demonstrate that as gearing increases, the increase in the cost of equity precisely offsets the effect of more cheap debt so that the WACC remains constant. The final one is Modigliani and Miller (M&M) with tax, in this theory, Debt, because of tax relief on interest, becomes unassailably cheap as a source of finance. It becomes so cheap that even though the cost of equity increases, the balance of the effects is to keep reducing the WACC.

Whichever theory you believe, whether there is or isn’t tax, provided the gearing ratio does not change the WACC will not change. Therefore, if a new project consisting of more business activities of the same type is to be funded so as to maintain the present gearing ratio, the current WACC is the appropriate discount rate to use. In the special case of M&M without tax, you can do anything you like with the gearing ratio as the WACC will remain constant and will be equal to the ungeared cost of equity. The condition that gearing is constant does not have to mean that upon every issue of capital both debt and equity also have to be issued. That would be very expensive in terms of transaction costs. What it means is that over the long term the gearing ratio will not change. That would certainly be the company’s ambition if it believed it was already at the optimum gearing ratio and minimum WACC. Therefore, this year, it might issue equity, the next debt and so on, so that the gearing and WACC hover around a constant position.