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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

A company raises extra debt while keeping its business risk unchanged. Under the Modigliani-Miller propositions with corporate tax, what is the effect on WACC as gearing increases?

With corporate tax, WACC falls as gearing increases. Interest is tax deductible, so the tax shield makes debt cheaper, and the higher cost of equity does not fully offset this benefit under the Modigliani-Miller model with tax.

  1. AWACC rises because equity holders demand more return
  2. BWACC is unchanged because of the tax shield being offset
  3. CWACC falls because of the tax shield on interestCorrect
  4. DWACC rises because debt is riskier than equity
  5. WACC is independent of tax

Explanation

With corporate tax, interest is deductible, creating a tax shield. Although the cost of equity rises with gearing, it does not fully offset the cheaper after-tax debt, so WACC falls as gearing rises.

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