The finance director of Benga Ltd. wishes to find the company‟s optimal capital structure. The cost of debt varies according to the level of gearing of the company as follows:
The company‟s ungeared equity beta (asset beta) is 0.85. The risk free rate is 6% per annum and the market return is 14% per annum. Corporate taxation is at the rate of 30% per year.
(a) Estimate the company‟s optimal weighted average cost of capital.
(b) Recommend whether or not the company should adopt the optimal capital structure identified in (a) above explain the factors that might influence the capital structure decision.
The optimal gearing is 40% debt, 60% equity at which WACC is lowest and value of the firm is maximized.
(b) (i)the model ignores the costs associated with high gearing such as:
Agency costs to monitor and control actions of the management Bankruptcy/financial distress costs
Exhaustion of tax shield if interest charges are more than EBIT
(ii) High gearing will affect credit rating of the firm and will affect the action of institutional investors who prefer low gearing (high credit rating)
(iii) Liability to raise additional capital due to high gearing level.
(iv) Manager‟s attitude to risk – high gearing means high financial risk and since managers are generally risk averse, they will prefer low gearing (low risk) to safeguard their jobs.
(v) There are other theories of capital structure such as pecking order theory, MM prepositions I and II etc apart from the static trade-off theory described above.
(vi) The financing mix adopted the firm will directly affect the firms operating income and managers need to consider this fact.