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The financing decision
As a company increases its gearing i.e. the amount of debt in its capital
structure, two things happen to the WACC:
1 debt is a cheaper source of 2 the equity holders perceive
finance than equity (lower more risk caused by the
risk and tax relief on increase in debt, so the
interest) so the WACC falls cost of equity rises and
by introducing more debt hence WACC rises
The different gearing theories interpret the net effect of these two
factors in different ways.
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