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Sir
1) regarding a)
Answer says ‘the company’s cost of capital increases because the lower debt level reduces the extent to which the WACC can be reduced due to the lower cost of debt’.
I am confused with this sentence. Could you please explain this?2) will lowering debt level increase or decrease WACC? Because when i calculate debt side alone in WACC,
Before: 0.049×0.5×0.8= 0.0196
After. : 0.046×0.231×0.8= 0.0085
This shows fall in debt side.
Is this wrong apporach?Thank you sir
Your calculations in (2) are correct and are the same as the answer. However this is only part of the WACC calculation.
Lower gearing means that there will be more equity and the cost of equity is higher then the cost of debt. As a result the WACC overall will be higher.This all relates to the theories of gearing (and Modigliani and Miller) which you should remember from Paper FM (was F9). Higher gearing results in a lower WACC whereas lower gearing results in a higher WACC.
Do watch my free lectures on the impact of financing (and if needed the free Paper FM lectures on Chapter 19 of the free Paper FM lecture notes).
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Thank you sir
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