Business finance : theory and practice

Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
investment in securities, in the UK at least, is undertaken by the institutions rather
than by individuals. Nor is it necessary that every investor in the economy seeks to
exploit any mispricing in order to correct it. The action of a couple of investors, well
placed to benefit from the situation, would be sufficient. Probably the weakness of this
assumption is not sufficient to call the MM proposition too seriously into question.
MM also made the implicit assumption that the corporate cost of borrowing does
not increase with the level of gearing. This seems less plausible, and is a point to which
we shall return later in the chapter.
‘There are no bankruptcy costs’
This assumption suggests that if a business were to be liquidated, the shareholders
would receive, in exchange for their shares, the equivalent of their market value immediately
before the liquidation. This assumption envisages a situation where, as a result
of a business defaulting on interest and/or capital repayment, it is liquidated at the
instigation of lenders. This sort of action would obviously be more likely with very
highly geared businesses.
The assumption is invalid since dealing costs would be involved in the disposal of
the business’s assets, legal costs would arise in formally bringing about the demise of
the business and, perhaps most importantly, the market for real assets is not generally
efficient in the same way that capital markets seem to be. This last point implies that
a machine worth £1,000 to Business A does not necessarily have that same value to
Business B, because B, for some reason, may not be able to use it as effectively as A.
Before the liquidation, A’s equity value may have been based partially on a £1,000
value for the machine, but when the machine comes to be sold it may realise only £500.
Furthermore, there are costs of administering a potentially bankrupt business, even if
it is saved.
This assumption’s lack of validity undermines the MM proposition in its broad
form. It is doubtful, however, whether the assumption is a very important one where
gearing levels are moderate, which appears typically to be the case in practice. On the
other hand, the existence of bankruptcy costs may well be the reason for the modest
gearing levels that we tend to see in real life.
‘Two businesses identical in income (cash flow) and risk exist,
one all-equity, the other geared’
This assumption is most unlikely strictly to be true. It seems not, however, to be an
important impediment to the validity of MM’s proposition. Stiglitz (1974) showed that
it is not necessary for two such businesses actually to exist in order for the proposition
to be valid.
‘There is no taxation’
This is clearly invalid. MM were much criticised for this fact and were forced to reconsider
their proposition because of it.
The revised after-tax version asserts that market forces must cause
V G = V U + TB G
where B G is the value of the business’s borrowings and T is the relevant corporation
tax rate, at which loan notes interest will be relieved (allowed as a deduction from the
corporation tax that the business would have to pay were it not for the existence of this
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