Optimal Gearing & WACC in a nutshell
Hi all! Let's break down capital structure theory in a straightforward way. Traditional theories can be complex, but this unprecedented approach simplifies everything for total clarity. Part 1: Optimizing Gearing Gearing—the balance between debt and equity—is set at 50:50. While this ensures equal financing, it results in a high weighted average cost of capital (WACC), which reduces profitability. Part 2: Optimizing WACC By optimizing WACC, the cost of capital decreases, leading to higher profits. The internal rate of return (IRR), which merely indicates the discount rate at which net present value (NPV) is zero, remains unaffected. A higher IRR is preferable since it always exceeds WACC. The Trade-Off Ultimately, capital structure is a risk-return trade-off between the cost of capital, WACC, and gearing. The preferred setup can be programmed based on specific financial goals. And just like that—voilà!—capital structure theory is just few steps. Forgot t...
