There is a non-linear relationship between the cost of equity and gearing. (b) The cost of equity rises as the level of gearing increases and financial risk increases. Beyond this level, the cost of debt will increase. (a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing.

(e) Taxation, for the timing being, is ignored. (d) Business risk is also constant, regardless of how the company invests its funds. (c) The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings. There are no transaction costs for issues. (b) The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt.

(a) The company pays out all its earnings as dividends. The assumptions on which this theory is based are as follows: The optimal capital structure will be the point at which WACC is lowest.Ģ.2 The traditional view of capital structure is that there is an optimal capital structure and the company can increase its total value by suitable use of debt finance in its capital structure. Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The Traditional View of Capital Structure 1.1 Describe the traditional view of capital structure and its assumptions.ġ.2 Describe the views of M&M on capital structure, both without and with corporate taxation, and their assumptions.ġ.3 Identify a range of capital market imperfections and describe their impact on the views of M&M on capital structure.ġ.4 Explain the relevance of pecking order theory to the selection of sources of finance.Ģ.

Geared and ungeared beta