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Dear Tutor,
As the profitability of the firm increases, the value of its equity rises, which causes a shift in the gearing of the firm. This can cause the firm to move away from its optimum capital structure.
Now, in the Kaplan kit, i dont understand why they say that occasionally the firm will have to increase gearing by issuing more debt to maintain the optimum capital structure?
Isnt the firm’s optimum capital structure where the WACC is the lowest? So if the gearing level falls, the wacc will infact improve further and so will the optimum gearing structure according to the traditional theory.
Then why the need to raise more debt to “spring back to optimum level”??
According to the traditional theory, there is indeed a level of gearing at which the WACC will be a minimum.
Just suppose is is 60% equity and 40% debt.
The if the gearing changes – whether it is more equity or whether it is more debt – then the WACC will be higher.
So…..if the value of equity increases – suppose it makes it 70% equity and 30% debt – then the WACC will be higher, and to get back to 60% and 40% they will have to issue more debt.
(According to Modigliani and Miller, however, the more debt the better (because of the tax relief on the interest) and so if M&M holds true then they should always want to raise more debt).
My lectures will help you on this – especially the Paper F9 lectures on it – where I illustrate with simple graphs.
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