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进入论坛>> (c) A discussion of capital structure could start from recognising that equity is more expensive than debt because of the relativerisk of the two sources of finance. Equity is riskier than debt and so equity is more expensive than debt. This does not dependon the tax efficiency of debt, since we can assume that no taxes exist. We can also assume that as a company gears up, itreplaces equity with debt. This means that the company’s capital base remains constant and its weighted average cost ofcapital (WACC) is not affected by increasing investment.
The traditional view of capital structure assumes a non-linear relationship between the cost of equity and financial risk. As acompany gears up, there is initially very little increase in the cost of equity and the WACC decreases because the cost of debtis less than the cost of equity. A point is reached, however, where the cost of equity rises at a rate that exceeds the reductioneffect of cheaper debt and the WACC starts to increase. In the traditional view, therefore, a minimum WACC exists and, as aresult, a maximum value of the company arises.
Modigliani and Miller assumed a perfect capital market and a linear relationship between the cost of equity and financial risk.
They argued that, as a company geared up, the cost of equity increased at a rate that exactly cancelled out the reductioneffect of cheaper debt. WACC was therefore constant at all levels of gearing and no optimal capital structure, where the valueof the company was at a maximum, could be found.
It was argued that the no-tax assumption made by Modigliani and Miller was unrealistic, since in the real world interestpayments were an allowable expense in calculating taxable profit and so the effective cost of debt was reduced by its taxefficiency. They revised their model to include this tax effect and showed that, as a result, the WACC decreased in a linearfashion as a company geared up. The value of the company increased by the value of the ‘tax shield’ and an optimal capitalstructure would result by gearing up as much as possible.
It was pointed out that market imperfections associated with high levels of gearing, such as bankruptcy risk and agency costs,would limit the extent to which a company could gear up. In practice, therefore, it appears that companies can reduce their
WACC by increasing gearing, while avoiding the financial distress that can arise at high levels of gearing.
Time allowed
Reading and planning: 15 minutes
Writing: 3 hours a
ALL FOUR questions are compulsory and MUST be attempted.
Formulae Sheet, Present Value and Annuity Tables are on
pages 6, 7 and 8.
Do NOT open this paper until instructed by the supervisor. P
During reading and planning time only the question paper maybe annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
The Association of Chartered Certified Accountants
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