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(c) Whilst gearing up, the company should appraise projects at the cost of the extra finance
raised (the marginal cost of capital).
(d) Once optimal gearing has been achieved (and is maintained) then projects should be
appraised at the cost of the extra finance raised. However, since the WACC will remain
unchanged, the cost of the extra finance will be equal to the WACC.I didn’t understand which they r indicating to? Can u explain? Also what is perfect market?
A company will always want to borrow in the cheapest way.
If there is a level of gearing at which the WACC is a minimum, then this is the best level of gearing – looking at the graph you can see that if the company then increases the gearing the WACC would increase; similarly if they reduce the gearing then the WACC would increase.Therefore the company should get to the optimum level of gearing and raise future finance in such a way as to keep to that level of gearing.
If they do that the WACC will stay constant at its minimum value.
Also, since if the WACC is staying constant then the cost of the extra money raised must be equal to the WACC.We should always appraise projects at the cost of the money raised. So……in the exam we always assume that the company is maintaining its level of gearing and therefore we appraise at the WACC.
A perfect market is one where share prices react instantly to changes in expectations, and where there are no transaction costs.
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