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September 10, 2018 at 9:23 am
Hi Sir, just wanted to confirm if I am correct in my understanding, from what I understood, MM theory does not holds true in practice, whereas the traditional theory may hold true practically, because the cost of equity(practically) does not necessarily tends to rise in a way, to keep the WACC constant. However, according to the traditional theory(practically), WACC does decreases as the gearing increases, upto a certain point, after which, the increase in cost of equity & cost of debt(due to higher gearing) become more significant, resulting in an increase in WACC. Moreover, I’m struggling to understand, on what basis does MM assumed the cost of equity to rise in a precise way?
John Moffat says
September 11, 2018 at 8:31 am
Subject to certain assumptions (which are listed in the lecture) M&M proved a formula that relates the cost of equity to the level of gearing. This formula is not examinable in Paper FM and neither are you expected to be able to prove the formula. (The proof is actually not so hard, but would take too long to type out here and is irrelevant for the exam anyway)
The reason M&M may not work perfectly in real life is not because their formula is wrong but because the assumptions they make do not all hold perfectly true in real life.
September 11, 2018 at 11:17 am
So practically, the formula holds true to some extent, but not absolutely. Thankyou 🙂
September 11, 2018 at 3:48 pm
That is correct, and you are welcome 🙂
August 22, 2018 at 1:27 pm
Sir thanks a lot. Excellent lecture.
August 23, 2018 at 5:36 am
Thank you for your comment 🙂
May 31, 2017 at 11:19 pm
You are fantastic! Many thanks for your work.
June 1, 2017 at 5:54 am
Thank you very much for the comment 🙂
April 8, 2017 at 8:58 pm
I have a question about the WACC here.. You said that MM said that it doesn’t matter whether you raise equity or debt, the overall cost will remain the same to the company. But how does that mean that the value of the firm will also stay the same? I am a bit confused 🙁
Thank You for reading
April 9, 2017 at 7:58 am
The value of the firm depends on the future cash flows and the cost of capital (just as with sales, the market value is the PV of the future dividends).
If the WACC stays the same then the total MV will stay the same also.
(But appreciate that the WACC only stays constant when there is no tax)
December 1, 2016 at 12:47 pm
Many thanks for your helpful and useful lectures and notes.
I have a misunderstanding on the level of gearing.
In my perception is that the debt will reduce the level of gearing, due to the tax benefit.
In the notes pg 99, M&M with corporation tax, its written the higher level of gearing (due to the tax) the lower the WACC.
Please correct me in order to understand it deeper.
December 1, 2016 at 2:57 pm
Gearing is simply ameasure of the proportion of long-term borrowing in the company.
The more borrowing there is, the higher the gearing.
Since debt gets the benefit of the tax relied, the more debt there is (i.e. the higher the gearing) the lower will be the WACC.
December 2, 2016 at 10:45 am
Sir thank you for your clarification.
December 2, 2016 at 10:56 am
You are welcome 🙂
May 31, 2016 at 12:38 pm
Good Day Sir, I would like to appreciate the kind of clarity and quality you deliver in these lectures. I was and am always a fan of your lectures. Your f5 modules was a huge factor in helping me clear it in my first attempt. I thank you for that. As far as f9 is concerned, are your lectures and notes and the open tuition question bank sufficient to crack the exam or should I be thorough with my text book as well sir? (Kaplan publishing)
May 31, 2016 at 2:45 pm
Thank you for your comments.
Although obviously the more reading you do the better, our lectures do cover everything needed to be able to pass the exam well. However, it is vital to get as much practice as possible, and more important than using a Study Text is to get a Revision/Exam Kit and work through as many questions as possible.
April 27, 2016 at 4:03 pm
hi John, In the lecture, while discussing traditional theory, you said that ”in a perfect world the cost of debt would remain constant because there is no risk.” I think apart from risk, there are various other factors which could lead to a change in the return required by lenders, as you explained in your previous lectures that people demand a rate of return due to various reasons, maybe if the banks are paying an interest of 10% & we raise debt through bonds, people will demand a rate of at least 10% or above. So even if there is no risk, the lenders might change their required return, due interest rates fluctuations or other reasons, am I right?
February 8, 2016 at 6:52 pm
Sir, I am bit confused about the bankruptcy risk. The Miller and Modigliani without tax theory says that Cost of equity will increase with more debt and it will offset the effect and WACC remains constant. I understand that WACC not increasing clearly shows that they ignored bankruptcy risk. But as per my understanding the Cost of equity goes higher only with the risks associated with it as shareholders panic and they want more returns and bankruptcy is one of the main risk, Isnt Bankruptcy in their minds and that is a result of the cost of equity going higher?
February 9, 2016 at 8:40 am
You are obviously not working through the chapters in order, because the chapter on capital structure (chapter 13 in the lecture notes) explains why gearing creates more risk of shareholders.
February 9, 2016 at 5:36 pm
Sir I understand why gearing creates more risk for shareholders. But here i am confused about the bankruptcy they talk about The Modigliani and Millers theory assumes there is no bankruptcy risk and the interest payments on debt and the dividends of shareholders cancel out each others effect. What i really dont understand is when u say we assume no bankruptcy i just dont understand how that works. What i am concerned with is Cost of equity its going higher with more debt one reason is of course interest payments shareholders want more return with more debt being introduced but the reason is automaticly the bankruptcy risk? The fear of company running out of funds is automaticly there? So howcome u say that we assume no bankruptcy?
February 9, 2016 at 5:39 pm
My main confusion is with the theory of this assumption and more concerned with the cost of equity going higher with debt. I really understand that of course with more gearing its creating more risk for shareholders but shouldnt that risk also be bankrptcy. This aspect of bankruptcy is not completly ignored?
February 10, 2016 at 6:09 am
In practice, certainly there is the fear of bankruptcy. However, in developing their theory M&M ignored this completely. They only considered the risk due to the fixed interest payments created by higher gearing leading to greater fluctuations in the amounts available to shareholders.
October 17, 2015 at 2:35 pm
Graph 3.1 shows the cost of debt alone to be lower than the the cost of equity and WACC.suppose we r fully debt financed wouldnt the overall cost be the maximum of cost of debt which is lower than the constant WACC(as per graph).
So is the graph correct in that regard?
October 17, 2015 at 3:46 pm
As I explain in the lecture, at very high levels debt takes on the risk of the business and can no longer be regarded as risk free.
October 18, 2015 at 5:41 am
Am sorry I didnt quite get u .so is the graph ryt or wrong?
Let me make my ques once more clear to u
Even at high levels if the cost of debt didnt rise till the wacc level(as per the graph) then hw will MnM model of constant WACC be establishd?
October 18, 2015 at 6:46 am
In theory the cost is debt would rise to the WACC because of what I wrote before. If they were all debt financed the debt would take on all the risk of the business and therefore require the same return as equity would if it were all equity financed.
However this is all hypothetical because it is not possible to be all debt financed (and it is assuming no tax).
The graph is only meant to be illustrative.
October 18, 2015 at 7:18 am
I had already understood wht u said there.it was tht the rise of cost of debt in the graph which didnt meet the wacc level which made things a bit confusing.So I can well assume tht the grph is not 100 percnt correct?
Thanks for the quick reply:-)
October 18, 2015 at 8:08 am
The graph is not meant to be 100% correct – that would never be possible and is completely irrelevant. You cannot possibly draw a correct graph in real life, and you are never required to draw a graph in the exam (although it is one way of explaining the idea, which for some people is easier than writing it in words).
What matters is that under the traditional theory, the WACC stands to change and that therefore there has to be a minimum. That is all!!
Calculations and graphs are never required. This is purely an illustrative graph – illustrative graphs do not attempt to be accurate.
October 18, 2015 at 8:48 am
I didnt know abt illustrative graphs n their accuracy.thts new to me.
Thanks tht ws so helpful
Keep up the good work
April 15, 2015 at 1:29 pm
Sir i have a question that If the company is entirely finance by 100% of Equity and 0% of Debt(as u mentioned in the question) then where did the cost of Debt come from (i.e 10% give in the question above)
April 15, 2015 at 3:38 pm
Firstly the example was only an illustration (and as I explained in the lecture, you could not be expected to do any numbers in the exam, just to be able to write what M&M said).
Secondly, however, it is still possible to obtain a cost of debt borrowing even if you don’t borrow any! (I do not borrow money from the bank, but I know what interest I would be charged if I did borrow 🙂 )
April 19, 2015 at 3:54 pm
April 1, 2015 at 3:02 pm
May i know for chapter 19 answers to examples 3 have a sentence ‘ New : Eg + Dg = 35 + 10 x 0.3 = 38M ‘ , what that means ?
March 19, 2015 at 7:04 pm
Mr Miller was a very clever man. He came up with this theory which we are all studying. Then he set up a trust (or whatever its called) where people put in alot of money so he could invest it on their behalf. And it collapsed. makes me wonder why am i even studying when this doesnt sort of make sense in the real world out there. Just saying as i see it. I guess u learn the real deal through experience rather than theory. Guess thats just the way it is. No wonder Albert Einstein hated a prescribed way of learning. Now its just more evident why the richest are school dropouts. Great lectures on f9 on the brighter note. thankyou
August 2, 2015 at 1:54 pm
Good observation. Why are ACCA making us learn a theory which failed miserably in real life!!!!
August 2, 2015 at 4:57 pm
The collapse of his mutual fund was nothing to do with his theories. The theories that he and Modigliani came up with formed the basis of all financial management theory and have had profound affects. The requirement to produce Statements of cash flows is just one indirect result of their work. They didn’t receive a Nobel prize for nothing 🙂
March 14, 2015 at 6:25 am
I was watching this as part of my revision for P4, as it has come up in a past P4 question which I’m practicing and I had no clue of capital structures because I did F9 a long time ago but now I’ve refreshed my memory. Thanks.
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