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Dear Mr Mofatt,
I have one confusion about impact of debt-finaced acquisition and its impact to book gearing, market gearing and cost of capital.
1. Book gearing:
it is straightforward that book gearing will change as ratio of debt/(debt +equity) increased as book value of debt increased for raised funds.2. Market gearing and cost of capital
As i understand, market gearing is based on market value of debt and reflect perceived financial risk by investors.Question 2b, in Dec 2007 said, in case of acquisition financed by debt, change in market gearing will depended on distribution of surplus value from acquisition between shareholder of targeted and predator co.
If it is expected that, majority of additional value fall into targeted co’s shareholder, market gearing will increase.
The reason for this movement is due to, if this is the case, acquiring co’s shareholder will not earned value as expected and therefore required higher cost of capital. -> market gearing increase?Is that the proper reason or am i misunderstanding? i am actually confused about these cases.
Thank you in advance.
If debt is raised to finance any investment (whether it be an acquisition of another company or a normal project investment) then the raising of more debt will in itself automatically increase the gearing (whether book gearing or market value gearing).
The problem is as to what happens to the market value of equity when calculating market value based gearing.
On the one hand, more debt means more risk to shareholders. This is likely to increase their required return, which will reduce the market value of equity (which increases the gearing still further).
However, if the investment of the money raised it going to increase returns to shareholders (which is usually likely) then this will increase the market value of the equity (which on its own reduces gearing).It is this last point that the answer is really referring to. Which shareholders will get the benefit of the extra earnings. If the benefit is all going to the target company shareholders, then because of everything above, the gearing of the acquiring company is bound to increase. If on the other hand benefit was going to the shareholders of the acquiring company, then although gearing might still increase it will not be to the same extent.
As I understand from your explaination: if expected incremental value fall into target company shareholders -> higher cost of capital required by acquiring owner -> lower value of equity + together with higher debt value => higher market gearing.
The extent of increase or decrease in market gearing or eventually cost of capital will vary in each case, right?
Thank you Mr Moffat for your explaination.
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