Capital Gearing and the Cost of Capital
If an all-equity company undertakes a capital project using the marginal cost of equity as its discount rate, the total market value of ordinary shares should increase by the project's NPV. However, most firms use a mix of ownership capital and borrowed funds from financial institutions for new investments. The relationship between the two is termed capital gearing or leverage. A company is highly geared (levered) when it has a significant proportion of borrowing relative to shares in its capital structure. It is lowly geared when the ratio of debt to equity is small.
In Chapter Six we observed that corporate borrowing is attractive to management because interest rates on debt are typically lower than equity and often qualify for tax relief As a consequence, a judicious amount of debt introduced into a firm's capital structure should lower the overall or weighted average cost of capital (WACC) employed as a cut-off rate for the appraisal of new projects, thereby increasing their expected NPV and corporate value.
You will also recall from Chapter Six that a company's component capital costs are derived by identifying the opportunity cost of each fund source using valuation models that determine debt and equity yields under various guises. Thus, our current analysis answers a logical series of questions, given the normative assumption of financial management, namely maximum profit at minimum cost.
How do individual capital costs combine to define WACC for use in investment appraisal? How valid are the theoretical assumptions that underpin WACC computations? What are the real-world problems associated with WACC estimations?