ACCA FM · Guided practice (Show me how)
Chapter 19: The cost of capital – the effect of changes in gearing
Capital structure - the WACC across gearing levels
Two tables from the notes. Equity / Debt is the proportion of the company financed by each, at market values.
(a) The traditional view. Complete the table by calculating the WACC at each level of gearing.
| Equity / Debt | 100%/0% | 80%/20% | 60%/40% | 40%/60% | 20%/80% |
|---|---|---|---|---|---|
| Cost of equity | 20% | 22% | 25% | 30% | 35% |
| Cost of debt | 10% | 10% | 10% | 12% | 16% |
(b) Modigliani and Miller with corporation tax at 30% (the cost of debt shown is after tax, 70% of the pre-tax 10%). Complete the table by calculating the WACC at each level of gearing.
| Equity / Debt | 100%/0% | 80%/20% | 50%/50% | 40%/60% |
|---|---|---|---|---|
| Cost of equity | 20% | 22.5% | 30% | 35% |
| Cost of debt | 7% | 7% | 7% | 7% |
(a) The traditional view
Calculate the weighted average cost of capital at each traditional-view gearing level and identify the optimum.
(b) Modigliani and Miller with tax
Calculate the weighted average cost of capital at each Modigliani and Miller with tax gearing level and state the interpretation.
Opening this exercise…