FM Chapter 18 Questions – When (and when not!) to use the WACC for investment appraisal
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Hello Sir I have a little confusion:
Now if equity increases it means gearing decreases but weight for Ke increases therefore higher Ke and higher WACC is this correct?
If that’s the case then If debt is increased it means more interest is paid and therefore higher risk to shareholders so Ke will increase and WACC will increase as well!
So how can we deal with changes in the weights along with changes in the return rates for both, and what should we consider?
Higher gearing means a great proportion of debt in the company (and debt is cheaper than equity) but at the same time higher gearing creates more risk for shareholders and therefore the cost of equity increases. According to Modigliani and Miller then in the absence of tax the two effects balance out and the WACC stays constant. However when company tax exists the cost of debt is lower and therefore the higher the gearing the lower the WACC.
In the Paper FM exam this is for narrative questions, not for calculation questions (although obviously you can be asked to calculate the WACC itself).
Did you watch the free lectures before attempting the test, because all of this is explained in the lectures?
Hi John,
I am having a bit of a confusion in question number 3. You mentioned during your lecture that if the new investment was financed from equity this will decrease the risk on shareholders and it will cost less and vice versa if it was raised from debt. This contradicts the answers for the first two.
Thanks.
Never mind. I watched your lecture for chapter 19 and its clearer now.
Hi, in the 3rd question answer says the wacc will increase when gearing is increased (ie proportion of equity increases) but I thought level of gearing increases when levels of debt increase. I’m confused….
The third question does not mention the word gearing.
The answer is correct – if the finance comes from more debt finance (which mean more gearing) then the WACC will decrease.
If the finance comes from more equity finance (which means less gearing) then the WACC will increase.
Check the review quiz answer for the 3rd question, it mentions gearing and it says, ”the wacc will increase when gearing is increased (ie proportion of equity increases).” that statement is what is causing me the confusion, its conflicting with what you’ve written in the comment above.
Oops sorry – I will have the statement corrected. It should read “the WACC will increase when gearing is reduced (i.e. proportion of equity increases)”. However it doesn’t change the answer it terms of which of the statements in the question result in an increase or a decrease.
Greetings sir, The answer is yet to be corrected.