Page 20 - SCS May 2018 - Day 2 Suggested Solutions

CIMA MAY 2018 – STRATEGIC CASE STUDY

EXERCISE 2

Briefing paper

To: Board of directors
From: Senior manager
Subject: The Company’s gearing level

Introduction

The gearing level refers to how much of the company’s funds come from borrowings (debt) rather
than from the shareholders (equity). It is best measured as the ratio of debt: debt + equity (thus
showing the proportion of total funding that is provided from debt), and should if possible be
based on market values rather than book values.

The relative costs

Within reason, the use of debt funds to finance a company’s activities is generally considered to
be a good thing because debt funds are cheaper than equity funds. There are basically two
reasons for this.

Firstly, the debt investors require a lower rate of return on their investment as the risk involved in
the investment is lower than the risk involved in equity investment. The debt investors know they
will receive the same amount of interest each year regardless of the company’s performance;
whereas the return the equity investor gets varies with the company’s fortunes.

Secondly, the interest the company pays on its debt is a tax allowable expense (dividends paid to
equity shareholders are not).This effectively means that the tax authorities are paying part of the
expense thus reducing the final, after tax, cost even further.

The effect on equity

The above would seem to suggest that a company should use as much debt as possible (rather
than equity) to fund its operations. Doing so would apparently reduce the average cost of funding
the operations as we’d be using a high proportion of cheaper funds. (This average cost is called
the Weighted Average Cost of Capital – WACC.)

Unfortunately it’s not that simple. Increasing the proportion of debt funds will cause the rate of
return required by the shareholders (the cost of equity) to rise. This is because the need to pay
higher (and constant) amounts of interest increases the volatility of the equity returns. That is, it
increases the risk of the equity investors (called financial risk), which in turn increases the rate of
return they want.

The end result

Thus increasing the proportion of debt funds will have two opposing effect on WACC. The
increased proportion of cheaper debt funds will tend to reduce WACC, but at the same time the
resulting increased cost of the equity funds will tend to increase it. The end result (whether WACC
increases or decreases) therefore depends on the relative size of these two opposing effects.

76 KAPLAN PUBLISHING