The traditional approach
- Ke increases as gearing increases due to rising financial risk and, later, bankruptcy risk.
- Kd rises at high levels of gearing due to bankruptcy risk.
- As company starts to replace expensive equity with cheaper debt, WACC falls.
- As gearing continues to increase, Ke and Kd increase, offsetting the benefit of cheap debt.
Net income approach
- Capital markets are assumed to be perfect.
- No risk of bankruptcy so Kd curve is flat.
- Linear increase in Ke due to increasing financial risk.
- As company gears up and replaces equity with debt, benefit of cheaper debt is exactly balanced by the increasing cost of equity.
- No optimal capital structure is found.
- Arbitrage proof using companies A and B:
Net income 1000 1000
Interest at 5% Nil 150
Earnings 1000 850
Divide by cost of equity 10% 11%
MV of equity 10 000 7 727
MV of debt Nil 3 000
Total market value 10 000 10 727
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