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Business FinanceSection BFinancial ManagementSyllabus ECapital Structure

ACCA · Question 17.2 · Business Finance

CASE 2: AERODRONE TECH

AeroDrone Tech is an ungeared manufacturer of commercial delivery drones. The company currently has a cost of equity of 12%. The board is considering a major restructuring to issue debt and repurchase equity. The corporate tax rate is 25%. The risk-free rate is 4% and the equity risk premium is 6%.

According to Modigliani and Miller's theory with corporate taxes, what will be the impact of issuing debt on AeroDrone's Weighted Average Cost of Capital (WACC) and market value?

Answer options:

A.

WACC will remain constant and market value will remain constant.

B.

WACC will decrease and market value will increase up to an optimal point, after which bankruptcy costs outweigh tax shields.

C.

WACC will decrease and market value will increase up to a gearing level of 99.9%.

D.

WACC will increase because equity holders will demand higher returns due to financial risk.

How to approach this question

Recall the conclusion of M&M's 1963 paper (with taxes): The tax shield makes debt cheaper, and because they ignored bankruptcy costs, the optimal capital structure is nearly 100% debt.

Full Answer

C.WACC will decrease and market value will increase up to a gearing level of 99.9%.✓ Correct
Modigliani and Miller's theory with corporate taxes concludes that the tax shield on debt interest makes debt a cheaper source of finance than equity. Because M&M assumed perfect capital markets and ignored financial distress/bankruptcy costs, their model suggests that WACC will continuously fall and market value will continuously rise as gearing increases, implying a company should be financed almost entirely by debt.

Common mistakes

Confusing M&M with taxes with the Traditional View (which includes bankruptcy costs and has an optimal point).
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