Comments

  1. avatar says

    respected sir…
    i wana ask at 46:30 ….
    if a company has no interest and have 70 to pay without risk…
    and a company paying 80 with risk…
    its the geniune condition… why would anyone suppose to pay 20 interest for comparison…
    i mean if the company is not geared… it will pay 70…
    why we imagine 50???
    if there is no debt…

    • Avatar of johnmoffat says

      Firstly, I was only trying to make the point in a simple way – it is not necessary for the exam.

      However, we are not thinking about risk for the company – it is risk for the shareholder that we are concerned with (because it is the shareholders who fix the market value of the shares, and it is shareholders who determine the cost of equity)

      If the shareholders receipt of dividend is after payment of fixed interest then there is risk for the shareholder (as I explain the lecture).

      So it is not valid to compare the dividend received from a company that is paying interest out of its profits, with the dividend received from a company that is not paying interest – the risk for the investor is different (the more fixed interest is payable, the more risky the dividend).
      So to try and make the risks the same (so we can compare the two dividends), M&M had the investor in the ungeared company borrow money specifically so that they would have to pay fixed interest. The idea is that then in both cases the investor is receiving the dividend after payment of fixed interest and so we could compare the two.

      Again, the risk we are talking about is the risk to the investor – the shareholder. As is explained in the lecture, the more the fixed interest, the more the riskiness of the dividends.

  2. Avatar of Mahoysam says

    I find this really interesting, I have made up my mind now, I will choose P4 as an optional paper!
    At some level, it just doesn’t make much sense to me that the WACC remains constant if there was no tax involved! How can the fall in cost of capital as a result of raising more debt cancel out against the increase in dividend as a result of higher risk. It assumes that shareholders will require a higher return (because of risk) that amounts EXACTLY to the fall in the cost of capital because of cheap debt, doesn’t it? In real life, I don’t think that shareholders calculate the difference between debt cost and equity cost and then demand the dividend to increase by this much! Am I getting the point wrong here? – Perhaps this point is covered under the assumption that shareholders react reasonably to risk!

    Maha

  3. avatar says

    Dear John wat about the proposition my Mr Durand ( the net income approach and net operating income approach) where in the net operating income approach it says capital structure does not effect the WACC

    • Avatar of johnmoffat says

      What about David Durand?
      He was one of several people who criticised M&M because of the assumptions that they made and came up with other suggestions.
      However it is only M&M that is in the syllabus (together with knowledge of the main assumptions they made).

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