Investment Management and Portfolio Analysis

Question 01

AXYZ Company is a listed company. The company tracks the relationship between the level of gearing, cost of capital and firms value over the last 10 years. Recently, based on the historical data, the following observations are presented to the Chief Finance Officer (CFO).

Observation 01: The Overall weighted Average Cost of Capital of the firm is sensitive to the level of gearing. Upto 48% of gearing ratio, the WACC reduced gradually, and stayed constant till 65% of gearing and started to increase after that.

Observation 02: The relationship between gearing and firms value is inverse to the relationship to Cost of Capital. Whenever Cost of Capital reduces the firms value increases and vice versa.

The CFO seeks your assistance to understand this context.

Requirement

Relate the observation of AXYZ company to any of the best matching theory that explains the relationship between gearing ratio and firms cost of capital and value.

(10 Marks) (maximum 200 +/- 10% words)