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As always, i really appreciate your help John !
(textbook says that)
– in MM’s theory, debt interest is tax deductible so the overall cost of debt to the company is lower than in MM – no tax
– lower debt costs imply less volatility in returns for the same level of gearing, giving SMALLER INCREASES IN COST OF EQUITY
– the INCREASE IN COST OF EQUITY does not offset the benefit of the cheaper debt finance and therefore the WACC falls as gearing is increased.questions ( i have written in big cap in those part where i was not able to comprehend properly)
1. in the second line, why lower debt cost will lead to increases in cost of equity ?
is it because equity holders are concerned when there’s an increase in cost of debt but if gearing is increased substantially, lower cost of debt will arise as a result of tax interest relief and compensation for the volatility is lesser as compared to MM(with no tax) ???
(i generally understand what it means but it’s how to grasp properly)2. in the third paragraph, what does it mean by increase in cost of equity does not offset the benefit of the cheaper debt finance ?
( i can’t understand for this part)Dividends are volatile because profits are volatile. The more fixed interest payments are, then the more volatile dividends are, and vice versa. (I illustrate this with an example in the Paper F9 lectures on gearing).
If debt interest is tax allowable then the after tax interest is lower (than if it was not tax allowable) and therefore the dividends are less volatile. If the dividends are less risky then shareholders will not demand as high a return.The higher the gearing, the higher will be the cost of equity. However, at the same time there will be a greater proportion of ‘cheaper’ debt. More cheap debt reduces the WACC whereas higher cost of equity increases the WACC. According to M&M, the benefit of the cheap debt is greater than the extra cost of equity and so the WACC will fall.
To be honest, the chance of being asked to explain all this in P4 is remote. It is examined at F9 and so if you do want more then watch the free Paper F9 lectures on the theories of gearing.
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