Peter Atrill, Financial Management for Decision Makers, 6

th
Edition, Pearson Education Limited 2012
Slide 8.1
Relationship between risk and return
Return
(%)
Risk
Risk
premium
Risk-free
rate
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.2
The traditional view of the relationship between
levels of borrowing and expected returns
C
o
s
t

o
f

c
a
p
i
t
a
l

Level of borrowing
Optimal level of
borrowing (i.e. point at
which overall cost of
capital is minimised)
Cost of loan
capital
Overall cost
of capital
Cost of
ordinary share
capital
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.3
Relationship between the level of borrowing, the cost
of capital and business value: the traditional view
C
o
s
t

o
f

c
a
p
i
t
a
l

Level of borrowing
V
a
l
u
e

o
f

t
h
e

b
u
s
i
n
e
s
s

Level of borrowing
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.4
The MM view of the relationship between levels of
borrowing and expected returns
Cost of
capital
Level of borrowing
Cost of
loan capital
Overall
cost of
capital
Cost of
ordinary
share capital
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.5
Relationship between the level of borrowing, the cost
of capital and business value: the MM view
C
o
s
t

o
f

c
a
p
i
t
a
l

Level of borrowing
V
a
l
u
e

o
f

t
h
e

b
u
s
i
n
e
s
s

Level of borrowing
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.6
The capital structure debate
MM analysis based on the
following restrictive
assumptions:
No bankruptcy cost
Businesses exist with
identical operating risks
Perfect capital markets
No taxation
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.7
The MM view of the relationship between levels of
borrowing and expected returns (including tax effects)
Cost of
capital
Level of borrowing
Cost of
loan
capital
Overall
cost of
capital
Cost of
ordinary
share
capital
Peter Atrill, Financial Management for Decision Makers, 6
th
Edition, Pearson Education Limited 2012
Slide 8.8
C
o
s
t

o
f

c
a
p
i
t
a
l

Level of borrowing
V
a
l
u
e

o
f

t
h
e

b
u
s
i
n
e
s
s

Level of borrowing
Relationship between the level of borrowing, the cost of
capital and business value: the MM view
(including tax effects)