ADIB’s gearing ratio is lower relative to these banks except for Sharjah Islamic Bank. The high gearing ratio is not profitable for these banks because of the no tax advantage as we mentioned previously. National Bank of Abu Dhabi The optimal structure is ideally the structure where firm’s value is highest. As we know that market value of a firm is the present value of its future cash flows, discounted using WACC. Mathematically the value of a firm will be highest once we find the lowest WACC. The level of capital structure where WACC is lowest can be effectively called the optimal capital structure of a firm. Debt is regarded as a cheaper source of finance than equity due to two reasons; one is tax advantage of debt and second is the lower cost due to low risk. If we introduce more debt into a capital structure it will reduce the WACC as equity holders always require more returns than debt holders. By this introduction of debt, the WACC will fall but WACC is actually the weighted average of cost of debt and cost of equity so when we introduce more debt it will increase the gearing levels and thus the risk for shareholders. Shareholders will require more returns consequently and at very high levels of gearing risk for debt holders will also increase and they also will also require high returns. Lowest WACC can be achieved somewhere between the highest and lowest levels of gearing. In our case the bank is based in no tax world so no advantage can be made of debt. The beta of company is also lower than the market which resulted in lower cost of equity; in fact cost of equity is still very close to the cost of debt and if we incorporate more debt it will rise. Cost of debt also rises as gearing level increases; this is because of increased credit risk and firm’s ability to pay interest on time. Current cost of capital of the bank is 4.97% and it will increase if more
ADIB’s gearing ratio is lower relative to these banks except for Sharjah Islamic Bank. The high gearing ratio is not profitable for these banks because of the no tax advantage as we mentioned previously. National Bank of Abu Dhabi The optimal structure is ideally the structure where firm’s value is highest. As we know that market value of a firm is the present value of its future cash flows, discounted using WACC. Mathematically the value of a firm will be highest once we find the lowest WACC. The level of capital structure where WACC is lowest can be effectively called the optimal capital structure of a firm. Debt is regarded as a cheaper source of finance than equity due to two reasons; one is tax advantage of debt and second is the lower cost due to low risk. If we introduce more debt into a capital structure it will reduce the WACC as equity holders always require more returns than debt holders. By this introduction of debt, the WACC will fall but WACC is actually the weighted average of cost of debt and cost of equity so when we introduce more debt it will increase the gearing levels and thus the risk for shareholders. Shareholders will require more returns consequently and at very high levels of gearing risk for debt holders will also increase and they also will also require high returns. Lowest WACC can be achieved somewhere between the highest and lowest levels of gearing. In our case the bank is based in no tax world so no advantage can be made of debt. The beta of company is also lower than the market which resulted in lower cost of equity; in fact cost of equity is still very close to the cost of debt and if we incorporate more debt it will rise. Cost of debt also rises as gearing level increases; this is because of increased credit risk and firm’s ability to pay interest on time. Current cost of capital of the bank is 4.97% and it will increase if more
my-corporate-finance-project.docx