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Under this theory, it explains that debt can be introduced and is cheap only till the optimal point of gearing. And after this point, debt is no longer cheap. The reason for debt to not be cheap after the optimal point is because the company is already highly geared by the time it reaches the optimal point and so the banks would charge a very high rate of interest to compensate for the risk the bank takes in giving debt to a highly geared co. Is this right Sir? It is my way of thinking.Is it right?
Secondly, debt is tax-deductible. For eg, investors reqd. return is 8% and the cost to the company would be 6% post tax { kd(1-t) }.
Here in this eg, the cost to co. is reduced because debt is given tax relief.
My doubt is, would the investors be given 8% as their return or 6%? If 6% is given, who will give the remaining 2%, as the investors have given the debt with the promise that they will be given 8%…Sir, where all do we assume debt is risk free? Is it only in ‘ ungearing betas’ and ‘Modigliani’ questions?
The traditional theory of gearing is that there is a level of gearing at which the WACC is a minimum (and therefore the market value is a maximum). However, it is not because the banks will charge a high rate of interest. It is because the shareholders will require a higher return because of the higher risk, and there comes a time when the higher return required is greater than the benefit of the cheaper debt.
Debt is tax deductible for the company (not for the lender). So the lender will still be paid 8%. However paying the interest will save the company tax and the net cost to the company will therefore (in your example) only be 6%.
In proving their theory, M&M assume that debt is risk free.
As regards calculations in the exam, it is only relevant when ungearing and gearing betas using the asset beta formula (which is in fact derived from M&M’s theories 🙂 )Fully understood. Thank you so much. I enjoy all your lectures. I feel like saying it a million times. Your explanation is so logical..which is what I like the most!
Thanks so much again.This doubt is from the lecture impact of financing, example 2.
part b, There it is mentioned thus: ‘without debt, wacc = 20%, with debt, wacc = 18 something%.’I was trying to figure out that wacc .
equity-70% , debt- 30%cost of capital of equity- 20%
cost of capital of debt- 3.5%
[kd=i(1-t)/P0 = 1.5(1-0.3)/30]so wacc of equity= 14, wacc of debt= 1.05
Total wacc= 15.05%I am not getting 18% or so….:(
You cannot take a WACC approach for this question. It is an adjusted present value question.
Here the cost of equity of 20% is the cost of equity if there was no gearing (and the tax benefit of debt is added separately).The actual cost of equity would be higher than 20% because of the gearing.
We can only use the WACC to appraise if the gearing of the company remains unchanged.
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