F3 Chapter 6
F3 Chapter 6
F3 Chapter 6
Chapter 6
Downward force:
Upward force:
Net effect:
Clearly, the two factors identified have opposing impacts on the
weighted average cost of capital. The key questions are:
The graph showed a horizontal line for company value in the M &
M without tax theory.
The graph also showed a horizontal line for WACC in the M & M
without tax theory.
Again, the formula backs this up. If t=0, the formula reduces to
kadj = keu.
This shows that the WACC of the geared company is always the
same as the WACC of an equivalent ungeared company,
irrespective of the level of gearing.
With tax:
The graph showed an upward sloping line for company value in the
M & M with tax theory.
This is backed up by the formula, which shows that the higher the
value of B (value of debt), the greater the value of the entire
company should be.
As the company increases its gearing, the value of the entire
company (debt plus equity) increases.
We can see from the formula that the keg increases as the amount
of debt (VD) increases relative to the value of equity (VE).
c) M & M assumed that debt was risk free, and that kd would be
constant at all levels of gearing. In reality, an increased level of
gearing is likely to be perceived as risky by lenders, so the
interest rates on borrowings generally increase as gearing
increases. Views of other stakeholders and rating agencies
Tax exhaustion:
a) M & M's with tax theory suggests that the benefits of tax relief
on debt interest will help to reduce the company's cost of
capital at all levels of gearing. This is not the case in practice.
Thin capitalization=
a) Gearing:
b) Interest cover: