Question

Describe the impact of a.  gearing (aka financial leverage);

and

b. tax on the cost of capital.

Answer 1

a. Impact of gearing

The gearing is the amount of debt involved in the company. The higher the debt the more interest company has to pay. So it is necessary to have a optimal gearing ratio. If the cost of debt is higher than the rate of return then it would cause loss to the company.

To reduce the gearing ratio the firm may sell it debt and repay the debt.

b. Impact of tax on the cost of capital

If the cost of capital is tax deductible then the tax will reduce the cost of capital. Generally cost on debt is tax deductible as interest is allowed as tax deductible .So the cost of debt is reduced by the tax percentage. The cost of equity and preference capital are not affected by the tax.