Question

explain the meaning of break point and how it occurs in the capital structure of a company

Answer 1

Break point is the amount of the new capital that can be generated before there is an increase in the firms weighted average cost of capital.

Equity	Cost of equity	Debt	Cost of debt
0-99	13%	0-149	7%
100-199	15%	150-249	8%
200-299	17%	250-349	9%

Equity and debt mix 70 and 30%.

Total capital is 100. How much is equity =70 and debt is 30 hence the cost of equity is 15% and debt is 7%.

now let say the total capital required is 200, equity is 140 and debt is 60 then this falls in the second category i.e cost of raising equity is 17%and debt is 7%. At this moment the weighted average cost of capital increases because of the increase in the cost of equity. Hence Between 100 and 200 capital there is some point at which it crossed from the first range to second range. That point is called as Break point. So it is the capital at which WACC goes up.

We have to find that capital. lets say x is the capital required .i.e when the 70% of X =100, the cost of capital goes up.

Sofirst break point for equity occurs at X=100/70%=142.85.

when the total capital is 142.85 the weighted average cost of capital goes up.

this is first break point. second break point at 200/70=285.71(140 equity , 60 Debt).

For cost of debt , the first break point occurs at =150/30%= 500,

second break point occurs at 250/30%=833.

AT these points the WACC of the firm will go up.

WACC 0 833 142.85 28507 500 Capital Reused.

Break point = amount of capital at which cost of capital changes/weight of the component in the capital structure.

That means after we have used that amount of capital we have to pay a higher cost of capital. Means if we have to raise more than 142.85 it will cost us more to raise equity and hence the amount of capital, and for debt if we raise more than 500 then cost of capital increases.