Capital structure: is there an optimum gearing level?

The tradition view of capital structure was that firms should increase gearing from a low level because the firm would be financed by cheaper borrowed funds, therefore the weighted average cost of capital would fall. By doing so the discounting of future cash flows at the lower WACC produces a higher present value and so increases shareholder wealth. So arguably if the aim of the firm should be to maximise shareholder wealth, the view regarding capital structure is that the WACC should be the lowest it can possibly be, right? Well, no.
There are many advantages to debt, the obvious being the costs, but there is also tax relief because interest is deducted from the profit and loss. However, the decision reaches and impasse, by increasing debt, and thus increasing interest, the WACC goes down, which increases the market value of the firm. However, by increasing interest, there is less left in the pot for dividends to shareholders so you are decreasing shareholder wealth! Problems with dividends carries even further if the firm has a bad year, because the interest must be paid regardless of the firm's performance, the volatility of dividends will increase. Furthermore, the increase in volatility also increases the risk to the shareholders, therefore, in the concept of fair return for the risk, the dividends should be increased, which increases the WACC.


So, bearing all this in mind, is there an optimum gearing level?


The traditional theory regarding the cost of capital assumes that the WACC is U shaped, so there is an optimum gearing level. However, there are too many complicating contextual factors to take into consideration for different companies and therefore an optimum level of gearing cannot be established for each company, which explains why there are so many different gearing ratios amongst companies.