Why wacc is u shaped

The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels.

No optimal capital structure exists. In , when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically. As debt became even cheaper due to the tax relief on interest payments , cost of debt falls significantly from Kd to Kd 1-t.

Thus, WACC falls as gearing increases. Companies should therefore borrow as much as possible. Optimal capital structure is Companies are discouraged from following this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion.

All factors which Modigliani and Miller failed to take in account. Modigliani and Miller assumed perfect capital markets; therefore, a company would always be able to raise funding and avoid bankruptcy.

In the real world, a major disadvantage of a company taking on high levels of debt is that there is a significant possibility of the company defaulting on its increased interest payments and hence being declared bankrupt. If shareholders and debt-holders become concerned about the possibility of bankruptcy risk, they will need to be compensated for this additional risk.

Therefore, the cost of equity and the cost of debt will increase, WACC will increase and the share price reduces. If this with-tax model is modified to take into account the existence of bankruptcy risks at high levels of gearing, then an optimal capital structure emerges which is considerably below the In most large companies, the finance providers principals are not able to actively manage the company.

Therefore, the management may make decisions that benefit the shareholders at the expense of the debt-holders. This action could potentially benefit shareholders as they may benefit from the higher returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on company performance. Thus, the debt-holders do not receive a return which compensates them for the level of risk.

These restrictive covenants may limit how much further debt can be raised, set a target gearing ratio, set a target current ratio, restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the type of activity the company may engage in. As gearing increases, debt-holders would want to impose more constrains on the management to safeguard their increased investment. Management do not like restrictions placed on their freedom of action.

Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them. The fact that interest is tax-deductible means that as a company gears up, it generally reduces its tax bill. The tax relief on interest is called the tax shield — because as a company gears up, paying more interest, it shields more of its profits from corporate tax. The tax advantage enjoyed by debt over equity means that a company can reduce its WACC and increases its value by substituting debt for equity, providing that interest payments remain tax deductible.

However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief. This is the point where companies become tax - exhausted, ie interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd 1-t to Kd.

Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing. The WACC will initially fall, because the benefits of having a greater amount of cheaper debt outweigh the increase in cost of equity due to increasing financial risk. The WACC will continue to fall until it reaches its minimum value, ie the optimal capital structure represented by the point X.

At very high levels of gearing, bankruptcy risk causes the cost of equity curve to rise at a steeper rate and also causes the cost of debt to start to rise. Shareholder wealth is affected by changing the level of gearing. There is an optimal gearing level at which WACC is minimised and the total value of the company is maximised. Financial managers have a duty to achieve and maintain this level of gearing.

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Your Practice. Popular Courses. Economy Economics. Key Takeaways The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value. Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity. This theory depends on assumptions that imply that the cost of either debt or equity financing vary with respect to the degree of leverage.

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