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Sir would it be correct to write following in scenerio of increase in debt level and in scenerio of decrease in debt level
Increasing level of debt
Due to increase in level of debt, financial risk increases. This lead to increase in ke.
As a result WACC will increase. However, due to higher proportion of debt in financial structure WACC will reduce. Thus, if ke has a greater impact then overall WACC will increase. On the other hand, if cost of debt has a greater impact then overall WACC will decreaseReducing level of debt
Due to decrease in level of debt, financial risk decreases. This lead to decrease in ke.
However, WACC will increase because lower level of debt reduces extent to which WACC can be reduced due to lower kdIt is true, except for the fact that according to Modigliani and Miller then increasing levels of debt will cause the WACC to fall. This is because although the cost of equity will indeed increase, the cost of debt will fall to a greater extent because not only is the investors required return on debt lower but because also the company gets the benefit of the tax relief on the debt,
But sir then in Kingtom co D20 why examiner has written following answer that:
The increase in the cost of equity has pushed the weighted average cost of capital upwards.
However, the higher proportion of debt in the company’s finance structure, with debt having a lower cost than equity and also being tax-deductible, has pushed the weighted average cost of capital downwards.
Overall, however, the weighted average cost of capital has risen, meaning the increase in the cost of equity has had the greater impact.Your first post was not referring to any specific scenario and as I replied what you wrote was correct but you should have mentioned Modigliani and Miller if you were asked to discuss the WACC in general.
Kingtim is referring to a specific scenario and obviously MM’s theory is not holding because the WACC has increased!!
Sir if ask that to state M&M theory, then should I write the following?
“Due to increase in level of debt, financial risk increases. This lead to increase in ke. As a result, WACC will increase. However, due to higher proportion of debt in financial structure, with debt having a lower cost than equity and also being tax-deductible, WACC will reduce.” Correct?
It is correct, but do add that in theory it is the case (because as illustrated in Kingtim it might not be the case in practice 🙂 )
Thanks sir Now I have understood. You mean to say that we should write that:
Due to increase in level of debt, financial risk increases. This lead to increase in ke and in turn WACC. However, due to higher proportion of debt in financial structure, with debt having a lower cost than equity and also being tax-deductible, WACC will fall. (This is M&M law)
However, if ke has a greater impact then overall WACC will increase * (This statement is specific to scenerio in kingtom co).
Correct?
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