What is the optimal level of gearing according to the traditional theory?

The optimal level of gearing according to the traditional theory is identified as the point where the Weighted Average Cost of Capital (WACC) is minimized. Traditional capital structure theory posits that as a company increases its use of debt, initially, the cost of equity rises due to the higher risk associated with leverage. However, the overall cost of capital may decrease as the company benefits from the tax shield provided by debt financing, making borrowing more attractive.

At a certain level of gearing, the benefits of additional debt financing start to overshadow the rising costs associated with higher risks, thus minimizing WACC. This is considered the optimal capital structure because it represents the point where the firm achieves the lowest possible cost of capital while maximizing its value. Beyond this point, WACC begins to rise again as the risks associated with additional borrowing increase significantly.

This understanding reflects the core of traditional theory, which suggests that there is a sweet spot in the capital structure that balances risk and cost effectively to enhance firm value.