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Capital structure theory

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Capital structure theory

  • This topic has 3 replies, 2 voices, and was last updated 6 years ago by John Moffat.
Viewing 4 posts - 1 through 4 (of 4 total)
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    Posts
  • August 16, 2016 at 3:19 pm #333594
    Anuja Nair
    Member
    • Topics: 365
    • Replies: 353
    • ☆☆☆☆

    Why are the following statements below, false?

    Question 1

    Statement 1: In the traditional view, there is a linear relationship between the cost of equity and financial risk.

    Isn’t this statement true? Because as the financial risk increases, the Ke increases too right ?

    Question 2

    According to both the traditional view and the Modigliani and Miller (II) view of capital structure :

    Statement 1 : The WACC is minimized at the maximum level of gearing.

    Why is this statement wrong ? The WACC is the lowest at the optimal point where the debt = 100% right?

    August 16, 2016 at 4:24 pm #333638
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 51532
    • ☆☆☆☆☆

    1. Higher financial risk does certainly mean higher shareholders required return, but there is no reason for it to be a linear relationship.

    2. It may be true for M&M with tax, but not true for the traditional view (watch my lectures because I do explain this).

    August 17, 2016 at 3:07 am #333697
    Anuja Nair
    Member
    • Topics: 365
    • Replies: 353
    • ☆☆☆☆

    Oh. For question 2 , I think i misinterpreted the question again. I thought the statements either can be true for M&M with tax or the traditional view. I didnt know that it’s suppose to be true for both the traditional and M&M with tax. Now, i get it. Thank you sir.

    August 17, 2016 at 6:21 am #333724
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 51532
    • ☆☆☆☆☆

    You are welcome 🙂

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