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ACCA Applied Skills · Financial Management · Capital structure theories and practical considerations

According to Modigliani and Miller's capital structure theory in a world without taxes, what happens to a company's weighted average cost of capital (WACC) as it increases its level of gearing?

WACC stays constant. Under Modigliani and Miller without taxes, the extra return shareholders demand for higher financial risk exactly offsets the cheaper debt, so WACC and total firm value are unaffected by gearing.

  1. AIt falls steadily because debt is cheaper than equity
  2. BIt remains constant because the cost of equity rises to offset the cheaper debtCorrect
  3. CIt rises steadily because of the increasing financial risk
  4. DIt falls at first and then rises after an optimal gearing level

Explanation

MM without tax states that the value of a firm and its WACC are independent of its capital structure. Although debt is cheaper, shareholders require a higher return as financial risk increases, exactly offsetting the benefit. The option showing WACC falling at first and then rising describes the traditional view, not MM.

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