Business finance : theory and practice

Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
£1.286). This implies that, were the second vessel to be financed by an issue of equity,
the value of each ordinary share would be £1, whereas if the second vessel were to
be financed by loan notes, the ordinary shares would be worth £1.286 each. In short,
the shareholders’ wealth would be increased as a result of borrowing instead of issuing
equity.
Too good to be true? Probably yes, yet there is nothing in the example that seems
too unreasonable. Expected returns on equities tend to be greater than those on loan
notes, so the 10 per cent interest rate is not necessarily unrealistic. Surely though, such
alchemy cannot really work. It cannot be possible in a fairly rational world, suddenly
to turn a 14 per cent return into an 18 per cent one, to increase a share’s price from
£1 to £1.286, quite so simply. Or can it?
To try to get to the bottom of this enigma, let us look at the situation from the point
of view of the suppliers of the debt finance. If there are 14 per cent returns to be made
from investing in yacht chartering, why are they prepared to invest for a 10 per cent
return? Why do they not buy ordinary shares in La Mer? Are they so naïve that they do
not notice the 14 per cent possibility? Perhaps they are, but this seems rather unlikely.
The difference between investing directly in yacht chartering, through the purchase
of shares in La Mer, and lending money on a fixed rate of interest is the different level
of risk. In the example, of the £140,000 p.a. expected profits from the second yacht,
only £100,000 would be paid to the providers of the new finance. The other £40,000
goes to the equity holders, but with it goes all of the risk (or nearly all of it).
As with all real investment, returns are not certain. Suppose that there were to be
a recession in the yacht charter business, so that the profits of La Mer plc fell to £70,000
p.a. from each vessel. This would mean:
– that is:
Profit from chartering (2 × £70,000) £140,000
Less: Interest (£1 million @ 10%) £100,000
£40,000
£40,000
= £0.04 per share
1,000,000
(Note that, had the second yacht been financed by equity, the return per share
would in the circumstances be £140,000/2,000,000 = £0.07, not quite such a disastrous
outcome for equity holders.)
From this it seems clear that borrowing provides an apparently cheap source of
finance, but it has a hidden cost to equity shareholders.
11.3 Business risk and financial risk
Table 11.1 shows the annual dividend per share for La Mer (assuming the second
vessel is acquired and that all available profit is paid as dividend) for each of the
two financing schemes referred to above (all equity and 50 per cent debt financed) for
various levels of chartering profits.
Borrowing enhances returns on equity over those that could be earned in the allequity
structure, where annual profits are above £100,000 per vessel. Where annual
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