Question
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
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:
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Determine the overall cost of capital for various proportions of debt finance and draw a graph to show the optimal capital structure. (20 marks)
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What is the advantage to a firm of financing at the optimal capital structure?
(5 marks)
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