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hi john, hope u r fine.
coden question, part a on the comment part, i get it it says as debt reduces..gearing reduces and cost of equity will also reduce as a result…but why does wacc increase?
and why does wacc increase generally speaking..?
This is really due to Modigliani and Miller.
They proved that as gearing increases, the WACC will reduce. The reason is that debt is tax allowable which makes debt borrowing cheaper. So even though the cost of equity will increase (due to higher gearing), the tax advantage on the extra debt more than covers the higher cost of equity and so the WACC falls.
The comment above is the same thing in reverse – i.e. gearing falling.
For a fuller explanation you really need to watch the Paper F9 lectures on Modigliani and Miller.
so in coeden case , the tax shielding on profits effect is substantially less as a result of reduction in debt amount and is outweighed by the higher cost equity leading to an increase in wacc? is that rgt?
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