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ACCA Strategic Professional · Advanced Financial Management · Impact of financing on investment decisions and adjusted present values

Dalton plc has a cost of equity of 15% and pre-tax cost of debt of 5%, with a debt to equity market value ratio of 1:4. Corporate tax is 20%. Debt is assumed risk-free, and Modigliani and Miller with taxes applies. What ungeared cost of equity should be used as the discount rate for the base-case NPV in an APV appraisal of a project with the same business risk?

The ungeared cost of equity is 13.33%. Using the MM-with-tax formula, weight the 15% equity cost by 4 and the after-tax debt cost of 4% by 1, then divide by 4.8, the equity plus tax-adjusted debt. Ignoring the tax adjustment gives 13.00%, which is wrong.

  1. A13.33%Correct
  2. B13.00%
  3. C12.80%
  4. D15.00%

Explanation

Keu = [Ke × E + Kd(1−T) × D] / [E + D(1−T)]. With E = 4 and D = 1: (15 × 4 + 4 × 1) / (4 + 0.8) = 64 / 4.8 = 13.33%. Ignoring tax gives 13.00%, and 12.80% is the existing WACC, which is geared and not the ungeared rate.

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