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February 8, 2016 at 6:52 pm
Sir, I am bit confused about the bankruptcy risk. The Miller and Modigliani without tax theory says that Cost of equity will increase with more debt and it will offset the effect and WACC remains constant. I understand that WACC not increasing clearly shows that they ignored bankruptcy risk. But as per my understanding the Cost of equity goes higher only with the risks associated with it as shareholders panic and they want more returns and bankruptcy is one of the main risk, Isnt Bankruptcy in their minds and that is a result of the cost of equity going higher?
John Moffat says
February 9, 2016 at 8:40 am
You are obviously not working through the chapters in order, because the chapter on capital structure (chapter 13 in the lecture notes) explains why gearing creates more risk of shareholders.
February 9, 2016 at 5:36 pm
Sir I understand why gearing creates more risk for shareholders. But here i am confused about the bankruptcy they talk about The Modigliani and Millers theory assumes there is no bankruptcy risk and the interest payments on debt and the dividends of shareholders cancel out each others effect. What i really dont understand is when u say we assume no bankruptcy i just dont understand how that works. What i am concerned with is Cost of equity its going higher with more debt one reason is of course interest payments shareholders want more return with more debt being introduced but the reason is automaticly the bankruptcy risk? The fear of company running out of funds is automaticly there? So howcome u say that we assume no bankruptcy?
February 9, 2016 at 5:39 pm
My main confusion is with the theory of this assumption and more concerned with the cost of equity going higher with debt. I really understand that of course with more gearing its creating more risk for shareholders but shouldnt that risk also be bankrptcy. This aspect of bankruptcy is not completly ignored?
February 10, 2016 at 6:09 am
In practice, certainly there is the fear of bankruptcy. However, in developing their theory M&M ignored this completely.
They only considered the risk due to the fixed interest payments created by higher gearing leading to greater fluctuations in the amounts available to shareholders.
October 17, 2015 at 2:35 pm
Graph 3.1 shows the cost of debt alone to be lower than the the cost of equity and WACC.suppose we r fully debt financed wouldnt the overall cost be the maximum of cost of debt which is lower than the constant WACC(as per graph).
So is the graph correct in that regard?
October 17, 2015 at 3:46 pm
As I explain in the lecture, at very high levels debt takes on the risk of the business and can no longer be regarded as risk free.
October 18, 2015 at 5:41 am
Am sorry I didnt quite get u .so is the graph ryt or wrong?
Let me make my ques once more clear to u
Even at high levels if the cost of debt didnt rise till the wacc level(as per the graph) then hw will MnM model of constant WACC be establishd?
October 18, 2015 at 6:46 am
In theory the cost is debt would rise to the WACC because of what I wrote before. If they were all debt financed the debt would take on all the risk of the business and therefore require the same return as equity would if it were all equity financed.
However this is all hypothetical because it is not possible to be all debt financed (and it is assuming no tax).
The graph is only meant to be illustrative.
October 18, 2015 at 7:18 am
I had already understood wht u said there.it was tht the rise of cost of debt in the graph which didnt meet the wacc level which made things a bit confusing.So I can well assume tht the grph is not 100 percnt correct?
Thanks for the quick reply:-)
October 18, 2015 at 8:08 am
The graph is not meant to be 100% correct – that would never be possible and is completely irrelevant. You cannot possibly draw a correct graph in real life, and you are never required to draw a graph in the exam (although it is one way of explaining the idea, which for some people is easier than writing it in words).
What matters is that under the traditional theory, the WACC stands to change and that therefore there has to be a minimum. That is all!!
Calculations and graphs are never required. This is purely an illustrative graph – illustrative graphs do not attempt to be accurate.
October 18, 2015 at 8:48 am
I didnt know abt illustrative graphs n their accuracy.thts new to me.
Thanks tht ws so helpful
Keep up the good work
April 15, 2015 at 1:29 pm
Sir i have a question that If the company is entirely finance by 100% of Equity and 0% of Debt(as u mentioned in the question) then where did the cost of Debt come from (i.e 10% give in the question above)
April 15, 2015 at 3:38 pm
Firstly the example was only an illustration (and as I explained in the lecture, you could not be expected to do any numbers in the exam, just to be able to write what M&M said).
Secondly, however, it is still possible to obtain a cost of debt borrowing even if you don’t borrow any! (I do not borrow money from the bank, but I know what interest I would be charged if I did borrow )
April 19, 2015 at 3:54 pm
April 1, 2015 at 3:02 pm
May i know for chapter 19 answers to examples 3 have a sentence ‘ New : Eg + Dg = 35 + 10 x 0.3 = 38M ‘ , what that means ?
March 19, 2015 at 7:04 pm
Mr Miller was a very clever man. He came up with this theory which we are all studying. Then he set up a trust (or whatever its called) where people put in alot of money so he could invest it on their behalf. And it collapsed. makes me wonder why am i even studying when this doesnt sort of make sense in the real world out there. Just saying as i see it. I guess u learn the real deal through experience rather than theory. Guess thats just the way it is. No wonder Albert Einstein hated a prescribed way of learning. Now its just more evident why the richest are school dropouts. Great lectures on f9 on the brighter note. thankyou
August 2, 2015 at 1:54 pm
Good observation. Why are ACCA making us learn a theory which failed miserably in real life!!!!
August 2, 2015 at 4:57 pm
The collapse of his mutual fund was nothing to do with his theories. The theories that he and Modigliani came up with formed the basis of all financial management theory and have had profound affects. The requirement to produce Statements of cash flows is just one indirect result of their work.
They didn’t receive a Nobel prize for nothing
March 14, 2015 at 6:25 am
I was watching this as part of my revision for P4, as it has come up in a past P4 question which I’m practicing and I had no clue of capital structures because I did F9 a long time ago but now I’ve refreshed my memory. Thanks.
March 14, 2015 at 6:23 am
Thank you sir for this beautiful lecture.
Abdulrahman Al-Nuwairah says
January 18, 2015 at 9:50 pm
Please Mr. john tell me how to express my great of great thanks to you, words are never enough for such efforts, I need to thank you in more practical way… I really feel that you are a gift from Allah (god) … And as I said, words are never enough.
Should we comment, recommend, pay… You just say please.
January 19, 2015 at 7:22 am
Thank you very much
Please do recommend this website – the more people that use it, then the more we can provide.
November 14, 2013 at 8:01 pm
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…
November 14, 2013 at 8:44 pm
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.
November 14, 2013 at 9:29 pm
thanx a lotttttttttt….
got the point …
i knew its about risk to shareholders… i was just confused with the example… but the point is clear now…
November 14, 2013 at 9:39 pm
You are welcome
January 18, 2015 at 9:46 pm
Please Mr. john tell me how to express my great of great thanks to you, words are never enough for such efforts, I need to thank you in more practical way… I really feel that you a gift from Allah (god) … And as I said, words are never enough.
October 25, 2013 at 3:04 pm
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!
February 2, 2013 at 2:27 pm
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
February 3, 2013 at 4:17 am
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).
December 1, 2012 at 4:35 pm
Superb lecture Great !!!! Sir but i wanna ask you that what if the examiner asks to talk about what you suggest the company how to finance so what should we write ?? can you plz tell me
December 1, 2012 at 6:56 pm
@cris1993, It depends.
If it is just a general written part of a question then he will expect you to describe the traditional theory, M&M without tax, and M&M with tax.
If it is a question where you have had to do calculations first and then you are asked to comment on the different ways of raising finance that were in the question, then you will comment on the figures that you have calculated (for example, if you were asked to calculate the EPS for different ways of financing, then the one giving the higher EPS will be more attractive). But you will of course comment on whether the gearing has increased or decreased (and therefore the risk).
Rana Mateen says
October 16, 2012 at 6:23 pm
john moffat you are peerless, uncompareable, angelic, precious, sparkling, unique, special. may allah shower on you bundle of blessings all time.
June 25, 2012 at 10:04 am
Thats great, and you are welcome
June 24, 2012 at 12:11 pm
graph 3.1 is not wrong….it’s simply represent the mix of 2 different type of finance..
June 24, 2012 at 2:53 pm
@Ken, Graph is wrong. Read the notes about M&M without tax and my other reply below.
I will correct the graph in the next few weeks.
June 24, 2012 at 5:12 pm
ok, many thanks
and if there is a mix of equity and debt finance then the WACC will be constant but below 10%?
June 24, 2012 at 9:55 pm
What I was trying to say that: In this example we are taking 10% as a Equity cost of capital which is 100% but, instead say: if we take mix of Equity and Debt finance and say 40% and 60% wiith 10% and 5% cost of capital, then surely WACC will be between 10% and 5% constant, which prove this graph is correct? Please advice.
June 24, 2012 at 10:02 pm
@Ken, But if you bring in debt finance then the higher gearing will mean more risk to shareholders and so they will require a higher return and so the cost of equity will be higher.
In theory (according to Modigliani and Miller), if there is no tax, the cost of equity will increase to 17.5%.
The WACC will therefore be (40% x 17.5%) + (60% x 5%) = 10%
If there is no tax, then according to M7M the WACC will stay constant for all levels of gearing. (If there is tax then the WACC will fall with higher gearing because of the tax relief on the debt interest – for that see the next example in the Course Notes)
June 24, 2012 at 10:06 pm
IT MAKE PERFECT SENCE to me now!
Miss A.. says
November 23, 2012 at 8:05 pm
@johnmoffat, is the graph right now??
November 23, 2012 at 8:12 pm
@Miss A.., Of course it is.
June 14, 2012 at 8:28 am
Thanks for the good lecture but i would like to find out, if you look at the graph on 3.1 based on modigliani and millers’s theory will the WACC remain constant at 10percent or maybe a percentage lower then 10percent as illustrated in the notes?
June 14, 2012 at 1:41 pm
@sandycmkm, Sorry – the graph in the notes is slightly wrong. The WACC will stay constant at 10%.
June 24, 2012 at 12:08 pm
I disagree with @sandycmkm….WACC will always sit between Equity and Debt Only when Equity is 100% then the WACC is equal to Equity eg 10%…the moment any entity take any other form of finance WACC will change…I hope you guys get my point?
June 24, 2012 at 2:52 pm
Graph 3.1 is wrong.
When it is 100% equity then the WACC will equal the cost of equity.
Also, because it is illustrating M&M without tax, the WACC will stay constant whatever the level of gearing.
May 31, 2012 at 6:17 am
November 23, 2012 at 8:07 pm
@greenzstarr, great work
May 16, 2012 at 1:53 pm
i am really improving my knowledge of f9 from him..
May 6, 2012 at 1:54 pm
Yes, let all of us give credit to the f9 lecturer. He deserve it. I personally say kudos.
May 3, 2012 at 5:44 pm
I think John Moffat is very good indeed. I studied with Kaplan ih the UK and none of the lectures have the same ability to translate F9 on such an understandable – or less complicate – lecturer.
I failed F9 and know what I am talking about…
If you do read it or are told about it, believe me you are good.
April 4, 2012 at 11:38 pm
You are not only training us to be Chartered Accountants but also to be regconised as Global Accountants in the real World. What more? Continue to fail? No, we have someone who genuinely explains more than what other Lectures can. His name is John Moffat. I personally appreciate Joe everything you did including your commitment and time.
December 7, 2011 at 11:35 am
1 Day left b4 the exam & his lectures are a blessings……
he is like lender at the last resort 😉
Saad Bin Aziz says
December 5, 2011 at 9:56 am
yea thats correct.
November 29, 2011 at 8:43 pm
If you are after his last assumption which said share holders are indifferent to corporate gearing and personal gearing, I recon he has said the assumption was to, not to think about the consequences. That is before actually investing money, how would the shareholder react to the risk of the company going bankruptcy, where he is expecting some dividends, and also how does he react if the other company too goes bankrupt where he is actually borrowing money.
Ignore these two reactions, when actually investing & borrowing money. ie indifference to corporate gearing and personal gearing
November 29, 2011 at 12:40 am
I THINK THIS LECTURER IS THE BEST THING CREATED. HE HAS MADE THE LONDON SCHOOL OF BUSINESS VIDEOS LOOK LIKE MINCEMEAT. THIS MAN IS THE GREATEST. SO MUCH CLARITY IN HIS EXPLANATIONS. WONDERFUL…100%.
November 22, 2011 at 4:05 pm
i’m not fully understand what he say actually at the last…=(
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