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Dear John,
Hope you are fine. Thank you for your great lectures on FM. I watched your lectures on the effect of changes in gearing and I think some part of it made me confused! it would be great if you could help me no the bellow questions:
1- Is it correct to say that in the traditional theory we say raising more finance through debt is cheaper than equity but we do not know how to find the optimal level and we have to do try and error, but in M&M theory (with tax) we conclude the same idea but here we can also formulate the optimal level which the formula is out of F9 syllabus. ( I mean the only difference between traditional theory and M&M with tax is that in the second one we have formula to find the optimal level)?
2 – It is obvious that at the the optimal gearing level, we have the lowest cost of capital. But why we have the highest market value? Could we say the reason is that the market value of a company is equal to the market value of its shares and the market value of it shares is the present value of the future dividends discounted at the cost of capital and as the result the lower the cost of capital, the higher the present value of future dividend and the higher the market value of the shares. It is Correct?
3- One of the assumptions of M&M as written in the notes is that investors are indifferent between corporate gearing and personal gearing. I did understand it although I watched the lectures carefully! Could you please explain.
Thank you very much.
Kind regards1. Not quite correct. With the traditional theory, the WACC will change with gearing and so there must be an optimal level of gearing at which the WACC will be a minimum. However this optimal gearing might be anywhere.
With M&M (with tax) higher gearing will always mean lower WACC (except at extremely high gearing) and therefore all companies should be as highly geared as possible.2. Again not quite correct. What we are talking about is the total market value of the whole business, which is the market value of the equity plus the market value of the long-term debt borrowing. The total market value is equal to the total earnings (before interest) discounted at the WACC. So the lower the WACC, the higher the total market value. (It is only in Paper AFM that we actually do the arithmetic for this – for Paper FM it can only really be a small part of a written answer.)
3. This is a little annoying (not your question, but annoying of the ACCA) because they removed the proof of M&M from the syllabus (in AFM as well as FM), but still expect you to be able to state this assumption. If I showed you the proof then the assumption would be much more obvious, but would be wasting your time.
Basically, the proof is comparing an investment in shares in a company with no gearing with an investment in a similar company that does have gearing. The problem is that the risk of the two share investments would be different and so not a fair comparison. So to make the gearing risk the same, they have the person investing in the shares of the company without gearing, borrow money. In that way they are paying interest (just as the geared company is paying interest) and so they say the risk is the same. (i.e. personal gearing (borrowing money yourself) is the same as company gearing (the company borrowing money). The problem is that there is a difference – if the geared company goes bankrupt the shareholder is not liable to pay off the company borrowing. However, if the ungeared company goes bankrupt, the shareholder loses their shares but is still liable to pay their own borrowing. (So a related assumption is that M&M ignore the fear of bankruptcy.)
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