Traditional
Theory of Gearing
1. Cost of Equity Rises
Cost of equity rise with
increase in gearing, this is because shareholder suffers most of the financial
risk. Therefore at increase level of gearing, cost of equity start rising.
2. WACC falls
Despite
the fact that cost of equity is rising, WACC falls at increased level of
gearing up to certain limit of gearing, because the debt is cheaper than
equity. Therefore by introducing cheaper option, WACC tend to fall being an
average of cost of equity and cost of debt.
3. WACC Start Rising at High Gearing
WACC
tends to fall up to certain limit of gearing due to cheaper debt, however, this
effect does not hold for too longs, and after certain level cost of equity
rises with a share rate , which eliminate the effect of debt ,and therefore
WACC start rising after at very high level of gearing.
