Gearing Effects on cost of Capital
There are
three theories associated with debt Financing.
Traditional Theory
Tradition theory says that substitution effect and financial
effect balance each other at low gearing levels, however, at some high gearing level
that debt holder also take pressure of financial effect and hence the cost of
capital tends to rise at high level of gearing.
M & M without tax
MM says that substitution effect and financial effect balance
out each and other and therefore the WACC remains constant irrespective of any
gearing level. MM theory believes that investor are less interested in sources
of financing and more interested in operational cash flow and therefore if the
operational cash flow is being generated by the business the WACC will remain
unchanged.
M & M with Tax
In real business environment we deal with taxes and because
the debt financing is a tax deductible (result in tax saving/ reduces the tax
outflows), therefore they becomes cheaper as compared to equity. Hence with introduction
of more debt business can reduce its WACC.
|
Theory
|
Gearing Effect on WAC
|
|
Traditional theory
|
WAC minimized up
to certain level
|
|
M & M theory
without tax
|
WAC remains
unchanged
|
|
M& M theory
with tax
|
WAC minimized at high level of Gearing
|
