ExpertMinds LogoExpertMinds
Medium2 marksMultiple Choice
Business FinanceSection BBusiness FinanceCapital StructureModigliani and Miller

ACCA · Question 25 · Business Finance

Section B - Case 2: NeuroLink Prosthetics

Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.

Question: According to Modigliani and Miller's theory of capital structure WITH taxes, what happens to the WACC as a company increases its gearing (debt levels)?

Answer options:

A.

WACC remains constant regardless of the level of gearing.

B.

WACC continuously decreases because the tax shield on debt makes it cheaper than equity.

C.

WACC decreases initially but then increases as bankruptcy costs outweigh the tax shield.

D.

WACC continuously increases because higher debt increases financial risk and the cost of equity.

How to approach this question

Differentiate between M&M without tax (WACC is constant), M&M with tax (WACC falls continuously to 99% debt), and the Traditional View (WACC is U-shaped due to bankruptcy costs).

Full Answer

B.WACC continuously decreases because the tax shield on debt makes it cheaper than equity.✓ Correct
Modigliani and Miller's (M&M) 1963 theory incorporating corporate taxes argues that because interest payments are tax-deductible, debt provides a 'tax shield'. This makes debt inherently cheaper than equity. Because M&M's model ignores financial distress and bankruptcy costs, it concludes that a company should take on as much debt as possible (up to 100% gearing) to continuously lower its WACC and maximize firm value.

Common mistakes

Confusing M&M with taxes with the Traditional View (Trade-off theory), which correctly identifies that bankruptcy costs eventually cause WACC to rise.
24All questions26

Practice the full ACCA FM — Financial Management Practice Exam 6

32 questions · hints · full answers · grading

Sign up freeTake the exam

More questions from this exam

Q01Section A GlobalVax is a non-governmental organization (NGO) dedicated to distributing vaccines ...EasyQ02Section A QuantumCore, a domestic quantum computing startup, relies heavily on imported rare-ear...MediumQ03Section A VertiFarm Co operates a network of urban vertical farms. It is experiencing cash flow ...MediumQ04Section A DeepSea Minerals PLC is evaluating two mutually exclusive underwater extraction machin...MediumQ05Section A A municipal water desalination plant is seeking to raise capital in compliance with Is...Easy
View all 32 questions →