Optimal Capital Structure - Assignment Example

Increasing gearing (which means an increase in debt) increases the cost of equity and therefore consequently leads to an increase in WACC. Financial distress is a state whereby a company is not able to meet the agreements it had with its creditors which normally results in a company being termed bankrupt. The cost associated with financial distress is normally termed as costs of financial distress. Some of the costs of financial distress are classified into direct and indirect. Direct costs include; legal fees, auditors fees, and management fees. Some of the indirect costs involved are loss of goodwill, loss of trust by creditors, and loss of customers.

Method 2: the second method is used only when the risk imposed on a company remains the same as a result of its capital structure, the company is ready to incur as much debt as possible. The main aim of this method is to identify the level of debt at which the advantages of increased debt are not outweighed by the increase in risk that the financially distressed company is subjected to. It is also known as the intuitive view. The theory indicates that a firm should have the as ideal level of gearing at which its WACC is minimized.

Nevertheless, this theory does not indicate where the ideal level is and this leaves trial and error as the sole method of finding it. When gearing levels are low shareholders regard risk increases as marginal. This results in the cheapness of debt issues and this causes WACC to be lower. When gearing ratios are higher the volatility of shareholders' returns increases. Dominance in the cheapness of extra debt results in WACC increasing as the levels of gearing increase. In the case when the levels of gearing have escalated abnormally both equity and debt holders face a risk of bankruptcy, as a result, the cost of equity and the cost of debt rise with increased gearing, and this, therefore, causes WACC to rise further They disregarded the capital structure which was irrelevant in determining the cost of capital.