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Hi John,
Looking at the formula (Ke = Kie + (1-T)*(Kie-Kd)*Vd/Ve, this implies that the greater the difference between (Kie – Kd) the more the cost will be added to Kie (ungeared equity) and hence higher Ke (geared equity).
e.g. Kie 12% and two scenarios of Kd (6% and 3%). Assume Vd and Ve is 1:1 and tax is 30%.
It will be:
Ke = 12% + (1-30%) * (12%-6%) * 1/1 = 16.2%
Ke = 12% + (1-30%) * (12%-3%) * 1/1 = 18.3%Why does the geared equity increase more as it takes on debt with lower cost versus taking up debt with lower cost?
You must ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.
You really must stop treating this exam as though a maths exam, because it is not.
The lower the cost of debt then the higher the market risk free premium and therefore the higher will be the cost of equity, just as with CAPM.
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