The Cost of Capital – The Effect of Changes in Gearing – ACCA Financial Management (FM)
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hi SIr,
for the M&M theory graph the debt & WACC illustrate as increase at higher level of gearing. is that due to the higher level of risk, a higher interest is chargeable due to the risk and shareholder will be expecting an higher return due to the risk which made the WACC increased?
Yes 🙂
Good day sir, the assumptions which was given in the last part of the video is for M&M theory is it?
Correct.
Hi Sir!
I’m a bit confused, it said in the lectures that Debt is cheaper or less risky than financing from Equity. However, it is mentioned here that when more gearing (debt) is going to be riskier for Shareholders, thus, wanting a higher rate of return.
Can I get a clarification on this? Thanks!
I think there are two aspects which you have combined:
1) For someone choosing between lending money vs buying shares, the risk to them (of a- losing their money, and b- getting no return) is higher for equity than for debt. This is your first sentence.
2) If a company is highly geared (ie high debt in proportion to equity), a bigger proportion of the revenue is needed to pay the interest on that debt. The party that loses out should revenue decline is the shareholders as it is their dividends or reinvestment in the company that would be impacted. This is your second sentence.
Hope that helps
have enjoyed every bit of this lecture.thanks
Hi John,
first of all i want to thank you so much for your lecture about traditional theory and M&M about capital structure. you delivered this lecture in such a simple way, yet include all the important points, which should be there to make the students to comprehend the theories.
in the video you mentioned that M&M theory assumes that the debt is irredeemable. and this has caused the Kd to be in the consistent rate. is my interpretation about the assumption correct ?
thanks in advance for your response
Thank you for your comment 🙂
The proof of M&M (which is not required for the exam) does assume that the debit is irredeemable. However the fact that Kd is constant is because we assume also that the debt is risk-free. The assumption that it is irredeemable is because otherwise the gearing would change in the future due to having to repay it.
Thanks 🙂 once again, what a mind-blowing explanation.!
Pecking order theory is concerned with the raising of long-term capital (not short-term finance, which is what delaying payments is).
Hello sir. Please can tax benefits be applied to preference shares?
No. Because preference share holders get dividend and dividends are not tax allowable.
Hi John,
In terms of financing working capital , within the pecking order theory where would you place
withholding supplier payments?
Hello sir,
How can there be a cost of debt 10% in the example 1 when there is no debt at all. 0 % share of debt is given in scenario 1 of example 1?
Why not? Maybe you could borrow money from the bank at a cost of 10% – it doesn’t mean you will necessarily be borrowing it 🙂
Anyway, the graph is only of relevance in explaining what happens to the WACC and since they are not borrowing debt at 0% gearing, it is not included in the calculation of the WACC!!
That expalains it.
Thank you 🙂
You are welcome 🙂