Wegithed Average Cost of Capital and Gearing (2) Flashcards
Modigliani and Miller (MM) assumtpions for a mathematical model?
Investors are rational
There is no tax
Corporate debt is irredeemable
Capital markets are perfect
Without tax theory for MM conclusion?
Only investment decisions affect the value of the company
The value of the company is independent of the financing decision
With tax theory for MM conclusion?
That there is an optimal gearing level and that this is to maximise debt in the capital structure to generate maximum value for the shareholders
Why is the tax theory for MM not true in practice?
At high levels of gearing the risk of default on debt
Personal taxes exist so investors choose to inject equity instead of debt
Why do investors prefer injecting equity instead of debt?
If dividends are taxed at lower rates than interest income
Why must project’s business risk be considered?
It is not wise to finance high-risk projects with debt, as payment of interest is a legally binding commitment
Why must existing level of operational gearing be considered?
If this is high, the company may prefer to avoid more debt as this increases the level of fixed costs even further.
Why must tax exhaustion be considered?
Not enough profit to fully utilise the interest tax shield
When may a company restrict its level of gearing?
From the point at which interest payments exceed profi
Why must agency costs be considered?
At high levels of financial gearing, the control of the company may move away from the shareholders towards the debt investors
Why must costs of financial distress be considered?
The company may find that its costs of doing business start to rise
Advantages of retained earnings
No issue costs
No change in the company’s control structure
Management time is not consumed by paperwork
Advantages of issuing debt?
Debt is cheaper than equity
Issue costs are lower on debt than equity
Interest is tax allowable, which results in a tax shield
Disadvantages of issuing equity?
The cost of equity is high because equity investors are exposed to high risk
Dividends do not give a tax shield
Share issues take much time and effort to organise
