Capital Structure, Risk Adjusted Beta
and WACC
By Binam Ghimire
1
MV of a company: Meaning
 Market Value of a Company:
Future CashFlows/ WACC
 If we can decrease WACC by changing the gearing then
we can add value to the shareholders wealth
2
Impact of Gearing
 Should decrease WACC because Debt is cheaper
 Should increase WACC because more Debt means more
risk to shareholder so increases cost of equity
 Traditional theory says WACC is U shaped so find
optimal point at bottom and keep gearing at that level
 M&M theory (no tax) says Debt is cheaper but cost of
equity rises so WACC is constant. Gearing is irrelevant
 M&M (with tax) debt is cheaper and greater than the
related cost of equity rises. So WACC falls. Get as much
debt as possible
3
CAPM in Project Appraisal:
 Ungeared company (all equity firm) and CAPM
4
CAPM in Project Appraisal:
Example 1
 Toshack plc is an all equity company and has a cost of
capital of 17% p.a. A new project has arisen with an
estimated beta of 1.3, Rf = 10% and Rm = 20%.
 Required: What is the required return of the project
 What relationship does this have to the cost of capital of
the company
5
CAPM in Project Appraisal:
Example 2
 Johnson plc is an all equity company with a beta of 0.6.
It is considering a single year project which requires an
outlay now of $2,000 and will generate cash in one year
with an expected value of $ 2,500. The project has a
beta of 1.3, Rf = 10% and Rm = 18%
 Required: What is the Johnson’s cost of equity capital?
 What is the required rate of return of the project?
 Is the project worthwhile?
6
CAPM in Project Appraisal:
Example 3
 Mears Ltd is an all equity company with a beta of 0.9. It
is considering a project which has a beta of 1.2. Rf =
7% and equity risk premium = 6%. Calculate the
project specific cost of capital.
7
CAPM in Project Appraisal:
 Geared company (all equity firm) and CAPM
8
Introducing Debt finance into CAPM :
 CAPM can be extended to take gearing
 When a company is planning to diversify into a different
sector
 The risk of the new sector will be different
 The job is to calculate the cost of capital which can
reflect the risk of the new sector
9
Betas:
 In an ungeared company it simply represents the
business risk. This is Beta of Asset
 In a geared company Beta represents both business
and other risk associated with debt. This is called Beta
of Equity (Business and finance risk)
 The beta of debt is generally very small so we may
ignore it
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Choosing a Beta (Converting the Beta of the company
into Beta of the proposed investing sector) :
 2 Steps:
Get an appropriate Asset Beta (same as a company
in that business)
Adjust it to your gearing levels. Make it an equity
beta
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Formula:
 The assets beta equals weighted average of the betas of
the various methods of financing, according to the
importance of each source of finance in the capital
structure

Ve
 a    e x
Ve  Vd (1  t )

 
Vd (1  t )
    d x
Ve  Vd (1  t )
 



 Given the beta of debt is 0 (The debt beta is usually
given as nil), the formula (when debt beta not given)
can be:

Ve
 a    e x
Ve  Vd (1  t )




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Formula:
 The beta of equity:
[V  V (1  t )]
  x
V
e
e
d
a
e
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Example 1:
 A Ltd is planning to diversify by investing into a different
market sector. The market sector has an average
geared beta of 1.8 and a debt to equity ratio of 2:3. A
Ltd. has a geared beta of 1.4 and a debt equity ratio of
1:3. Tax rate is 30%.
 Calculate the geared beta that A ltd should use when
calculating the cost of capital for this project.
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Example 2:
 Confectionary Co. (CC) is considering to move into
Theme Park (TP) Business. What is suitable cost of
capital?
 CC: Equity:Debt ratio= 5:2. The debt is risk free and
yields 11%. Beta = 1.1. Average Return on Stock
Market = 16%. Tax is 30%
 TP Ltd. Equity: Debt = 2:1, Beta = 1.59
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Solution (Example 2):
 Degear the Equity Beta of the co. doing same business
 1.59 * [2/ (2+1*(1-0.3)] = 1.18
 Regear your Asset Beta
 1.18 = ? X 5/ (5+1.4) =1.51
 Cost of Equity: Risk Free + Beta x Market premium or :
11% + 1.51 (16-11) = 18.55%
 Cost of Debt = 11 * 70% = 7.7%
 WACC = 18.55% x 5/7 + 7.7 % x 2/7=15.45 %

Ve
 a    e x
Ve  Vd (1  t )




16
CAPM in Project Appraisal:
Example 1
 Toshack plc is an all equity company and has a cost of
capital of 17% p.a. A new project has arisen with an
estimated beta of 1.3, Rf = 10% and Rm = 20%.
 Required: What is the required return of the project
 What relationship does this have to the cost of capital of
the company
 Required rate of return: Ks = Rf + b (Rm-Rf)
= 10% + 1.3 x (20 - 10)%
= 10% + 1.3 x 10%
= 10% + 11.3 %
= 21.3%
(This has no relationship with the cost of capital (17%) of
the company)
17
CAPM in Project Appraisal:
Example 2
 Johnson plc is an all equity company with a beta of 0.6.
It is considering a single year project which requires an
outlay now of $2,000 and will generate cash in one year
with an expected value of $ 2,500. The project has a
beta of 1.3, Rf = 10% and Rm = 18%
 Required: What is the Johnson’s cost of equity capital?
 What is the required rate of return of the project?
 Is the project worthwhile?
 Johnson’s Ks= 10% + 0.6 x (18-10)%
= 10% + 0.6 x 8%
=10% + 4.8%
= 14.8%
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CAPM in Project Appraisal:
Example 2
 The required rate of return of the project?
 Ks= 10% + 1.3 x (18-10)%
= 10% + 1.3 x 8%
=10% + 10.4%
= 20.4%
The return = 100 * [2500 – 2000)/ 2000] = 25%
The project is attractive because return (25%)>Cost
(20.4%)
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CAPM in Project Appraisal:
Example 3
 Mears Ltd is an all equity company with a beta of 0.9. It
is considering a project which has a beta of 1.2. Rf =
7% and equity risk premium = 6%. Calculate the
project specific cost of capital.
 Ks = 7% + 1.2 x 6%
= 7%+7.2%
= 14.2%
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