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 to mention, Kr = Ke when the company is funded wholly through equity or so it seems as I remember reading it. I just used it to show that different finances can be used and the lowest rate will be the best option. No need to discuss marginal WACC as the company cost of bringing in an added unit of capital cause our project is a startup.

Kr = Ke(1-T) (1-B)

Where,

• Kr= Required rate of return on retained earnings.
• Ke= Shareholder’s required rate of return.
• T= Shareholders’ marginal tax rate.
• B= Brokerage cost.

Other cost of capital formulas are available online.

 

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