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The Cost of Capital The Effect of Changes in Gearing
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Dear John wat about the proposition my Mr Durand ( the net income approach and net operating income approach) where in the net operating income approach it says capital structure does not effect the WACC
What about David Durand?
He was one of several people who criticised M&M because of the assumptions that they made and came up with other suggestions.
However it is only M&M that is in the syllabus (together with knowledge of the main assumptions they made).
Superb lecture Great !!!! Sir but i wanna ask you that what if the examiner asks to talk about what you suggest the company how to finance so what should we write ?? can you plz tell me
@cris1993, It depends.
If it is just a general written part of a question then he will expect you to describe the traditional theory, M&M without tax, and M&M with tax.
If it is a question where you have had to do calculations first and then you are asked to comment on the different ways of raising finance that were in the question, then you will comment on the figures that you have calculated (for example, if you were asked to calculate the EPS for different ways of financing, then the one giving the higher EPS will be more attractive). But you will of course comment on whether the gearing has increased or decreased (and therefore the risk).
john moffat you are peerless, uncompareable, angelic, precious, sparkling, unique, special. may allah shower on you bundle of blessings all time.
Thats great, and you are welcome
graph 3.1 is not wrong….it’s simply represent the mix of 2 different type of finance..
@Ken, Graph is wrong. Read the notes about M&M without tax and my other reply below.
I will correct the graph in the next few weeks.
@johnmoffat,
ok, many thanks
and if there is a mix of equity and debt finance then the WACC will be constant but below 10%?
@johnmoffat,
Dear Sir,
What I was trying to say that: In this example we are taking 10% as a Equity cost of capital which is 100% but, instead say: if we take mix of Equity and Debt finance and say 40% and 60% wiith 10% and 5% cost of capital, then surely WACC will be between 10% and 5% constant, which prove this graph is correct? Please advice.
Kind Regards,
Ken
@Ken, But if you bring in debt finance then the higher gearing will mean more risk to shareholders and so they will require a higher return and so the cost of equity will be higher.
In theory (according to Modigliani and Miller), if there is no tax, the cost of equity will increase to 17.5%.
The WACC will therefore be (40% x 17.5%) + (60% x 5%) = 10%
If there is no tax, then according to M7M the WACC will stay constant for all levels of gearing. (If there is tax then the WACC will fall with higher gearing because of the tax relief on the debt interest – for that see the next example in the Course Notes)
@johnmoffat,
IT MAKE PERFECT SENCE to me now!
many thanks
@johnmoffat, is the graph right now??
@Miss A.., Of course it is.
Thanks for the good lecture but i would like to find out, if you look at the graph on 3.1 based on modigliani and millers’s theory will the WACC remain constant at 10percent or maybe a percentage lower then 10percent as illustrated in the notes?
@sandycmkm, Sorry – the graph in the notes is slightly wrong. The WACC will stay constant at 10%.
@johnmoffat, @sandycmkm
I disagree with @sandycmkm….WACC will always sit between Equity and Debt Only when Equity is 100% then the WACC is equal to Equity eg 10%…the moment any entity take any other form of finance WACC will change…I hope you guys get my point?
Graph 3.1 is wrong.
When it is 100% equity then the WACC will equal the cost of equity.
Also, because it is illustrating M&M without tax, the WACC will stay constant whatever the level of gearing.
Fantastic!
@greenzstarr, great work
i am really improving my knowledge of f9 from him..
Yes, let all of us give credit to the f9 lecturer. He deserve it. I personally say kudos.
I think John Moffat is very good indeed. I studied with Kaplan ih the UK and none of the lectures have the same ability to translate F9 on such an understandable – or less complicate – lecturer.
I failed F9 and know what I am talking about…
If you do read it or are told about it, believe me you are good.
Thank you.
You are not only training us to be Chartered Accountants but also to be regconised as Global Accountants in the real World. What more? Continue to fail? No, we have someone who genuinely explains more than what other Lectures can. His name is John Moffat. I personally appreciate Joe everything you did including your commitment and time.
1 Day left b4 the exam & his lectures are a blessings……
he is like lender at the last resort
yea thats correct.
Lambyang,
If you are after his last assumption which said share holders are indifferent to corporate gearing and personal gearing, I recon he has said the assumption was to, not to think about the consequences. That is before actually investing money, how would the shareholder react to the risk of the company going bankruptcy, where he is expecting some dividends, and also how does he react if the other company too goes bankrupt where he is actually borrowing money.
Ignore these two reactions, when actually investing & borrowing money. ie indifference to corporate gearing and personal gearing
I THINK THIS LECTURER IS THE BEST THING CREATED. HE HAS MADE THE LONDON SCHOOL OF BUSINESS VIDEOS LOOK LIKE MINCEMEAT. THIS MAN IS THE GREATEST. SO MUCH CLARITY IN HIS EXPLANATIONS. WONDERFUL…100%.
i’m not fully understand what he say actually at the last…=(