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Adjusting WACC when gearing changes |

时间:2008-12-31 |

When discounting a project's cash flow at company's WACC (weighted average cost of capital), we assume that: 1. Same Business Risk: The project's business risk is the same as it of company's other asset and remains so for the life of the project. 2. Same Financial Risk: - Gearing Ratio. The project supports the same gearing ratio as company's capital structure, which remains constant for the life of the project. After study of F9 or P4, students are familiar with calculation of adjusted WACC when business risk differs. This article is going to discuss another topic -
Firstly we should review the concept of beta; there are two types of beta, equity beta and asset beta. Equity beta represents the systematic business risk and financial risk of a company, and asset beta reflects only the business risk of a company. If a company is all equity financed, the equity beta is exactly equal to asset beta. As long as a company operates in its existing business, its asset beta remains constant. However, the equity beta will change as company's gearing (financial risk) change, the higher gearing ratio, the higher equity beta. Therefore, we still could use the techniques of 'degearing and regearing' to adjust the company's WACC when gearing ratios changes, there are five steps:
In this step, the beat asset is unknown variable, and Debt and Equity is used the market value before the gearing changed. If you are not given beta debt, we normally assume beta debt is zero .The formula can be simplified as:
or (if beta debt is not given) The Debt and Equity is used the new gearing ratio after company adjusting its capital structure.
WACC =
S plc is a light weapons manufacturer whose equity: debt ratio is 79:21. The corporate debt yields 3% after tax. The beta value of the company's equity is 1.2. The average return on the stock market is 10.5% and return on treasury bill is 4%. The corporation tax rate is 30%. The company is considering to increase its gearing ratio to 50% (gearing ratio is defined as D/(D+E) on market value basis). Company estimate the after tax cost of debt may rise to 3.5% after gearing increase.
Calculate the company's WACC after gearing change Existing WACC calculation Ke =4 + (10.5 -4)×1.2 = 11.8% WACC = Adjusting WACC after gearing change
In some P4 examination questions, students are not told the information of beta whereas just giving the information of cost of equity (Ke), we still can degear and regear the Ke by using Modigliani and Miller's formulae, the steps are following:
(Given in exam) Keu is unknown variable, D/E ratio is used the market value before the gearing changed.
The Debt and Equity is used the new gearing ratio after company adjusting its capital structure.
WACC =
D plc is a heavy weapons manufacturer whose equity: debt ratio is 60:40. The corporate debt yields 6% before tax. The current cost of equity is 12.4%. The company is considering to increase its gearing ratio to 50% (gearing ratio is defined as D/(D+E) on market value basis). Company estimate the before tax cost of debt may rise to 6.2%. Corporation tax is 30%.
Calculate the company's WACC after gearing change Existing WACC WACC = WACC = 9.12% Adjusting WACC after gearing change
Kd = 6.2%
WACC = WACC = 8.82%
Some students may argue that we should use adjust present value (APV) method to evaluate a project when gearing / financial risk changes. This is correct. APV does not seek to adjust the discount rate; it evaluates both a project and its proposed financing package separately. APV = Base case NPV + PV of financing side effects In practice, we assume that the formulas for degear and regear are used in the circumstance where the capital structure changes in a relative small and steady manner, but if the firm plans significant changes in capital structure, the formula will not work, and you should turn to the APV method. To sum up, I recommend to students that: in real exam if you are given the new gearing ratio after capital structure changed, we should use degear and regear formulas, if you are not told the new gearing ratio, use APV method.
1. Brealey / Myers / Allen Corporate Finance: 8th edition, McGraw Hill International Edition, pp 516-525, 2006. |

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