- 15 Marks
FM – L2 – Q40 – Capital structure
Calculate optimal gearing level and WACC for a company given varying costs of debt, ungeared equity beta, and tax rate.
Question
A company has estimated that its cost of debt capital varies according to the level of gearing, as follows:
| Gearing | Cost of debt |
|---|---|
| 20 | 5.0 |
| 30 | 5.4 |
| 40 | 5.8 |
| 50 | 6.5 |
| 60 | 7.2 |
Gearing is measured as the market value of the company’s debt as a proportion of the total market value of its equity plus debt.
The rate of tax is 30%. The ungeared equity beta factor for the company is 0.90. The risk-free rate of return is 4% and the return on the market portfolio is 9%.
Required:
Identify the optimal gearing level and WACC.
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