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Could you please state the M&M theory with tax and without tax. And also please state pecking order theory.
Both are explained in full in my free lectures.
You cannot expect me to type out all of my lectures again here 🙂
I am having a little misunderstanding about M&M’s theory with tax and without tax. Please do correct me where you think I am incorrect below:
M&M theory (no tax):
This theory suggests that WACC remains fixed throughout the level of gearing. The more the company geared up the more the cheaper debt benefit can be achieved. The increase in the cost of equity is offset by the cheaper debt of borrowing by the company. Therefore, there is no optimal level in the no-tax world.(I don’t understand that how the cheaper debt borrowing can be beneficial even though there is no tax assumption in this theory)
M&M theory (with tax):
This theory suggests that cheaper debt employed by the company will always cause the WACC to reduce to a lower level because of the tax relief on interest payments of debt. Therefore, higher gearing is better.There is no much of a difference in both theories presented by M&M except the tax factor. (true?)
When there is no tax the WACC will stay constant for the reasons you have stated, and therefore it is irrelevant how a company raises finance.
(Cheaper debt borrowing is not beneficial for the reasons you typed).When there is tax, then again what you have written is correct, and companies should therefore be as highly geared as possible.
The thinking behind the two theories is the same, but there is a very big difference between the conclusions. If there was no tax then gearing would be irrelevant, but with tax (as in the case in real life) then it matters a lot how a company raised finance.
Have you actually watched my free lectures on this?
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