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on one hand, high gearing is undesirable because it makes the business risky but from M&M’s WACC, the cost of capital is higher than the cost of debt… in practical terms, what does this mean for business that is looking to grow?
The WACC will always be higher than the cost of debt – it has to be (and is nothing to do with M&M) because the cost of equity will always be higher than the cost of debt because it is more risky, and there will always be equity in the company.
The advantage of more gearing is that it gets tax relief which makes it a cheaper way of raising finance – that it why M&M say that a company should be as highly geared as possible (and that the WACC will fall with higher gearing).
For this reason debt finance is attractive to a business that wants to grow. They need to be aware however that it does create more risk for the shareholders, and that there will come a time when the debt needs to be repaid. If they have grown then repaying should not be a problem, but if they have not grown then they may have cash flow problems in repaying the debt.
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