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Hi, dear John,
another question in the mock
The company WACC can be used irrespective of the financing arrangements in an ideal world if the company pays no tax.
The company WACC can only be used as a discount rate if new finance is issued in the existing gearing ratio.
the second is false.
the explanation is:’issuing funds in the current gearing ratio does not mean we end up with the same gearing ratio as the equity value will also change to reflect the project NPV. The benefit of a positive NPV project only accrues to equity holders and not to debt holders.’I guess if the WACC under the assumption with no tax may still subject to the affect of business risk for example, the tax is one of the various elements?
Does M&M without tax theory consider the business risk?and I can clearly get the points in the explanation of the second option.
could you kindly explain this, thank you !
regards
The basic M&M theory only deals with the affect of gearing and does not take account of any changes in the level of business risk. So in the absence of tax the WACC is not affected by changes in the gearing, provided that the level of business risk stays the same.
We can of course deal with changes in the level of business risk using the CAPM formulae.
Do watch my free lectures on these topics. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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