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A company incorporates increasing amounts of debt finance into its capital structure, while leaving its operating risk unchanged.
Assuming that a perfect capital market exists, with corporation tax (but without personal tax), which of the following correctly describes the effect on the company’s costs of capital and total market value? Indicate, by clicking in the relevant boxes, whether the cost of equity, weighted average cost of capital and total market value would increase, decrease or be unaffected.
Cost of Equity
WACC
Total market valuecorrect answer: Cost of equity increases
WACC decreases
Total market value increasesI thought if a perfect capital market exists, tax should not exist and I therefore thought of MM No Tax theory rather than with tax theory. My answer is the same as the correct option but the concept behind it is different. In the marking scheme, they have applied MM with tax theory.
Can you please let me know what I’m doing wrong? Thank you in advance!
Yet you were applying the No Tax theory instead of the theory with tax. The key point is recognising that the presence of tax allows for the benefits of debt financing to enhance the firm’s value.
So in a perfect capital market with tax, the introduction of debt financing leads to a lower weighted average cost of capital (WACC) due to the tax shield on interest payments.
While the cost of equity increases because of the higher financial risk associated with increased debt, the overall WACC decreases.
This reduction in WACC results in an increase in the total market value of the company.
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