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ACCA AFM · Guided practice (Show me how)

Chapter 12: The Impact of Financing

MM with tax - the cost of equity and WACC as debt is raised

London plc is an ungeared company with a cost of equity of 15%. They propose raising debt at 8% (pre-tax) and have estimated that the resulting gearing ratio (debt:equity) will be 0.4. The rate of corporation tax is 30%.

Calculate (a) the cost of equity after raising the debt, and (b) the weighted average cost of capital before and after raising the debt.

Modigliani and Miller's proposition with tax (formulae sheet): ke = kie + (1 - T)(kie - kd) Vd / Ve, where kie is the cost of equity if ungeared, kd the pre-tax cost of debt and Vd / Ve the gearing at market values (debt to equity).

  1. (a) The cost of equity and of debt

    Calculate London plc's geared cost of equity and after-tax cost of debt.

  2. (b) The WACC before and after

    Calculate London plc's weighted average cost of capital before and after the proposed debt issue.

Opening this exercise…