F9 june 2011 Q 2c,

Discuss the director’s view that issuing traded bond will decrease the weighted average cost of capital of AQR and thereby increase the market value of the company.

I am confusing by the answer module.

This is my structure answer ,please give some advice whether is right or wrong.

( business valuation – Discounted cash flow)
( 1 + r ) = ( 1 + i ) / ( 1 + h)

inflation remain same,there if the WACC decrease,the discounted using will be lower,

Illutration before decrease wacc

discounted = 1.11/1.05
= 0.06

PAT = $50M

Company value = $500m

Illutration 2

WACC= 9%

discounted =1.09/1.05
= 0.04

PAT = $50m

company value= $1250m

Gearing = Debt / Equity.

Miller + modigliani theory with tax.(M+M)

Kd=(Interest-tax)/Market Value

M+M theory state company that finance 99.9% debt will maximum the benefit from tax relief on interest paid.Hence lower the WACC.

However the director did not take consideration of the gearing level and risk.
When the debt increasing the gearing and the equity remain same the gearing increase.
When gearing is very high,shareholder expected to have higher return therefore WACC increase,company value decreasing.

Director did not take consideration that if the company have insufficient profit to relief the interest paid.

In conclusion,issue bonds will reduce WACC and increasing the market value of the company but to a specific level where the gearing level is the same as the market average.

*When i compare the answer i dunno why the answer module use Marginal and average cost of debt,traditional view,market imperfection & pecking order.