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I want to ask why its is written that when gearing level increases cost of debt remain same,how is it possible as you keep on taking more debt then how can cost of debt remain same?
Second question is why in some question it is written that the project will be financed with debt and equity and we apply the current discount but we have learnded that when gearing level changes the current wacc is no longer applicable. But even then we use the current wacc to appraise project unlike apv question in which we use different factor because the project is financed in majority by debt.
THANKYOU in advance
In theory the cost of debt remains the same because the receipts to the investor carry zero risk (because the interest receipts are fixed – they are not uncertain as dividends are)
In practice, the cost of debt is likely to change with higher gearing because there is always the risk of bankruptcy. However, usually we ignore the risk of bankruptcy.
(Even then, at very high levels of gearing even the interest payments become risky and so certainly at very high levels of gearing the cost of debt will increase.)With regard to your second question, it depends what information we have. If there is a big change in the gearing then best is to use the adjusted present value approach, but otherwise we assume that in the long-term the level of gearing will remain constant in which case the WACC would remain constant.
In a similar vein Mr Moffat, I know gearing to be debt/debt+equity ,if a question information reads; ”” gearing ratio for Rover Airways,expressed as total debt to total capital(debt plus equity) is 60% and as total debt to total equity is 150% ”’ .which one are we expected to use for the gearing figure in computing the cost of capital and why not the other?
ThanksThe two are saying exactly the same thing!
Debt to equity is 150%, and so for every 100 equity there is 150 debt (total of debt plus equity is therefore 250)
Debt to total is 150 / 250, which is 60%.
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