L Ltd faces a cost of equity of 20% per annum and a cost of debt...

L Ltd faces a cost of equity of 20% per annum and a cost of debt of 12%. These rates apply up to a level of gearing of 75%, i.e. where the company is 75% debt financed. The cost of both debt and equity then rise as shown below:

Proportion of debt finance	Cost of debt	Cost of Equity
80%	14%	22%
85%	16%	24%
90%	18%	26%
95%	20%	28%
100%	22%	30%

Required:

Determine the overall cost of capital for various proportions of debt finance and draw a graph to show the optimal capital structure.
What is the advantage to a firm of financing at the optimal capital structure?

Expert Solution

Optimal Capital Structure is the one with LOWEST Overall Cost of Capital(WACC).

Therefore, Optimal Capital Structure is 75% in Debt.

If the Firm is financed at the Optimal Capital Structure, it will have Lowest WACC, hence, Higher Profitability.

jeff jeffy answered 2 years ago

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