(c) Acting as an external consultant to Semer, discuss the validity of the proposed strategy to increase gearing, and explain whether or not the estimates produced in (b) above are likely to be accurate. (10 marks)
(c) Report on the proposed adjustment of gearing through the repurchase of ordinary sharesThe effect of capital structure on the value of a company is not fully understood.Increasing the proportion of debt in the capital structure may reduce the overall cost of capital due to the interest on debt being a tax allowable expense. Even if a company is in a non-tax paying position, mixing additional low cost debt with relatively expensive equity might reduce the weighted average cost of capital. In such circumstances the proposed strategy to increase gearing would have some validity. However, increasing gearing can also bring problems. Risk to investors, and therefore the required returns on equity and debt, will increase as gearing increases. Very high levels of gearing might lead todirect and indirect bankruptcy costs, with a detrimental effect on cash flow and corporate value. Any benefits from increasing the proportion of debt in the capital structure will be to some extent offset as a result of increased risk with high gearing.The revised estimates of the effect on the cost of capital and value of Semer are not likely to be accurate. Reasons for this include:(i) The company will not be able to repurchase the necessary shares at their current market value. Approximately ￡240 million value of equity would need to be repurchased, or more than one third of the existing market value of equity.As repurchases take place it is likely that the share price will significantly increase.(ii) The cost of debt is unlikely to remain constant. As more debt is issued lenders will demand a higher interest rate to compensate for the extra risk resulting from higher gearing levels. The cost of equity will also increase with higher gearing. These effects will increase the weighted average cost of capital to a higher level than that estimated.(iii) The precise market values of debt and equity after the repurchase are unknown, and again will reflect the market attitudeto the new risk of the higher gearing.The value of the company is likely to be much lower than that estimated, as the weighted average cost of capital is likely to be underestimated.