Page 353 - Microsoft Word - 00 ACCA F9 IWB prelims 2017.docx
P. 353
Capital structure
An optimal capital structure? –
Company value and cost of capital
The objective of management is to maximise shareholder wealth. If
altering the gearing ratio could increase wealth then finance managers
would have a duty to do so.
MV of a company = PV of its future cash flows discounted at the
WACC.
Therefore if WACC falls, business value will rise.
3.1 Gearing and the effect on WACC
As an entity increases its gearing i.e. the amount of debt in its capital
structure, two things happen to the cost of capital (WACC)
1 debt is a cheaper source of 2 the equity holders perceive
finance than equity (lower risk more risk caused by the
and tax relief on interest) so increase in debt, so the cost
the WACC falls by of equity rises and hence
introducing more debt WACC rises
The different gearing theories interpret the net effect of these two
factors in different ways.
345
