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Dear Lisa,
According to the OpenTuition lecture notes and what I’ve read in the Kaplan textbook, for M&M theory (no tax), it should not matter how a business raises finance as the overall WACC, and hence, the value of the company, will not change.
However, there is a question in the latest Kaplan Kit (2024) which says otherwise.
Please read the question below and help me clarify why Statement 1 is false.THE QUESTION (extracted from the Kaplan Kit (2024); Page 88)
“Under M&M no tax which of the following statements are true?
1. It does not matter how a business raises finance.
2. Shareholders, given the M&M assumptions, will recognise the level of risk
inherent in any extra debt and compensate themselves by a commensurate
increase in required return to leave the company WACC unaltered and without
any inherent gain.”THE ANSWER in the kit is:
“Only statement 2 is true
It is a common error to think that M&M claimed ‘it does not matter how a business
raises its finance’. Their theory only looks at a high level comparison between equity
and debt. It does not then look at, for example, rights issues versus new issues of
shares or redeemable versus irredeemable debt. The second statement is true.”First of all
Why are you spending such time worrying about a OT question worth 2 marks!!!!
It’s a bad question but here goes…
The first statement oversimplifies the theory by implying that all forms of financing are equivalent, which is not the case.
M theory suggests that while the WACC remains unchanged in a perfect market, the specific methods of raising finance can have different implications for risk and return, which are not captured in the broad statement.
The second statement is true because it acknowledges that s/h will adjust their required return based on the perceived risk associated with additional debt, thereby keeping the WACC unchanged.
This reflects the understanding that while the overall cost of capital may not change, the risk profile of the company does, and shareholders will demand a higher return to compensate for that increased risk.
I was just worried because it could potentially be asked in the live exam
I’ve experienced that beforeThanks for simplifying it.
I do appreciate…As a tutor, what advice would you give to your FM students in the final week before exams?
I know this is not related to the topic I created on M&M, but based on your response (about time mgt) to the question I initially asked about M&M, I’m asking.
No matter how much preparation you’ve already done, finishing your revision in the right way can make all the difference. When it all comes down to it, you’ve just got to remember as much as you can and do your best!
So acknowledge that being prepared for your exam is an important way to avoid getting stressed about being under-prepared.
Revise for 30-45 minutes at a time before taking a short break.
Little and often is better than trying to study for long sessions in one go.Looking at your syllabus as topics…do you know enough?
Turn your focus more and more on looking at questionsThink in the exam ……I won’t be able to do everything, that’s the key!
As long as you do your best.
The exam itself, do the questions in a logical order. So section A is on everything, so my advice don’t start with that. I personally would start with section C, worth 40 marks on select topics.
Because you gain confidence as you get into the exam
But it’s your choice after all.
If a question really stumps you, flag it and move on
Plan to come back around and re-attempt but don’t waste your time, worrying about it….
Don’t rush when it comes to reading the question, understanding what you’re being asked to do and planning your answers……please take your time
Keep a positive mental attitude as much as you can.
You are a very intelligent young man …that I can see in the questions you ask.
Just do your best
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