CIMA F3 Exam Surgery
Past Paper Answer – Q40
Q40 ADS
(a)
How Modigliani and Miller’s (MM) capital structure theory differs from the traditional theory
The traditional view
The traditional view of capital structure and its effect on WACC is as follows.
(i)
It assumes that, as the level of gearing increases, the cost of debt will remain unchanged up to a
certain gearing level. Beyond this level it will increase as interest cover falls, risk of bankruptcy
increases and the amount of assets available for security falls.
(ii)
Cost of equity will rise as gearing levels increase, reflecting the increased financial risk.
Increased financial risk means that, as interest payments rise, the earnings available to pay
dividends to shareholders will become more uncertain as interest takes precedence over
dividend payments.
(iii)
WACC does not remain constant, but falls initially as the proportion of debt increases. It will
begin to rise as the increases in cost of equity (and possibly cost of debt) becomes more
significant.
(iv)
The optimum level of gearing is where the company’s WACC is minimised.
The traditional view about cost of capital can be illustrated by the following diagram.
Cost of
capital
ke
k0
kd
0
P
Where
ke
kd
k0
Level of gearing
is the cost of equity in the geared company
is the cost of debt
is the weighted average cost of capital
Point P illustrates the level of gearing at which WACC is at its lowest. This is known as the
optimal capital structure.
MM view of WACC (net operating income approach)
The MM view is similar to the traditional view in that it also assumes that cost of equity will
increase as the level of gearing increases (again due to increased financial risk).
However MM proposed that the total market value of a company, in the absence of tax, will be
determined by only two factors.
(i)
(ii)
The total earnings of the company
The level of business risk attached to these earnings
The capital structure of the company would have no effect at all on the company’s WACC. This
can be illustrated in the following diagram.
Cost of
capital
ke
ko
kd
0
Level of gearing
The diagram illustrates that the cost of debt remains unchanged as the level of gearing changes
and the cost of equity rises in such a way as to keep the WACC constant.
However the above model ignores taxation. If tax was introduced into the model, debt can be
beneficial to the company due to the tax shield available on interest. MM admitted that tax relief
on interest payments makes debt capital cheaper to a company and thus reduces WACC when
gearing is increased. They claimed that WACC would continue to fall up to a gearing level of
100%. This differs from the traditional view which states that there is an optimal capital
structure after which WACC will start to rise.
The following diagram illustrates the MM approach with taxation.
Cost of
capital
ke
ko
kd after tax
0
Gearing up to 100%
Limitations in the real world
Whilst MM’s theory is widely recognised, it has restrictions when applied to the real world.
(i)
MM assumes that capital markets are perfect (for example a firm will always be able to
raise funds for worthwhile projects). It ignores the increasing danger that very high levels
of gearing can lead to financial distress costs and agency problems (where managers may
be reluctant to invest if gearing levels are already high).
(ii)
The absence of transactions costs ensured that the arbitrage process worked. In practice
transactions costs will restrict this process.
(iii)
(b)
(i)
The theory assumes that individual and corporate gearing will be the same. This is
unlikely to be the case in the real world as even smaller companies are likely to have a
superior credit rating to individual investors.
Value of equity assuming new stores are financed by equity
1
PV =
x earnings for 2011
r-g
PV = A$127.1m/(0.09 – 0.04) = A$2,542m
(ii)
Financed by undated bond and using MM theory with corporate taxes
Value of equity
Vg = Vu + TBc
(where TBc is the tax savings on the debt)
Vg = A$2,542m + (A$250m x 0.25) = A$2,604.5m
VE = A$2,604.5m – A$250m = A$2,354.5m
Expected cost of equity
keg = keu + [keu – kd]
VD [1 - t]
VE
keg = 9 + (9 – 5) x [(250 x 0.75)/2,354.5]
keg = 9.3%
WACC
WACC = ke
 VE 
V + V 
 E D
+ kd (1 – t)
 VD 
V + V 
 E D
WACC = 9.3 x (2,354.5/2,604.5) + (5 x 0.75) x (250/2,604.5)
WACC = 8.41 + 0.36
WACC = 8.77%
(c)
Explanation of results
MM theory with taxation proposes that cost of capital will fall when debt is introduced into the capital
structure. The results in part (b) show this to be the case. Cost of capital with no debt was 9% (from the
question) whilst WACC when debt is introduced is 8.86%.
The value of the company increases when debt finance is introduced into the capital structure. With allequity finance, value of the company will be A$2,542m whilst with debt it increases to A$2,604.5m. This
increase is due to the value of the tax shield on the debt.
However it can be seen that the value of equity falls when debt is introduced (from A$2,542m to
A$2,354.5m. This is because the equity shareholders do not contribute any funds in the investment
project if debt is used but will contribute the full A$250m if equity finance is used. However the overall
value of the firm is increased when debt is brought in.
Shareholders’ wealth if equity finance is used will actually be A$2,542m – A$250m = A$2,292m but with
debt finance this increases to A$2,354.5m. The benefit of the tax shield (which is the difference between
the two figures) is enjoyed entirely by the equity shareholders.
Directors should not be concerned about the fall in the value of equity as they will be able to
demonstrate that the equity shareholders will ultimately benefit from the introduction of debt due to
the tax shield available.