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

Gaxon Co is financed entirely by equity and has a cost of equity of 12%. Under Modigliani and Miller's theory without taxes, Gaxon issues debt with a market value equal to 25% of the total firm value and uses the proceeds to buy back shares. The cost of debt is 6% and is risk-free. What is Gaxon's cost of equity after the change?

The cost of equity rises to 14.0%. Without tax, Ke geared equals the ungeared 12% plus (12% minus 6%) times debt to equity of one third, adding 2%. WACC stays at 12%, since extra cheap debt is offset by riskier equity.

  1. A14.0%Correct
  2. B16.0%
  3. C13.5%
  4. D10.5%

Explanation

MM without tax: Ke(geared) = Ke(u) + (Ke(u) - Kd) x D/E. D/V = 25% so D/E = 25/75 = 1/3. Ke = 12% + (12% - 6%) x 1/3 = 12% + 2% = 14.0%. Check: WACC = 0.75 x 14% + 0.25 x 6% = 12%, which is unchanged as the theory requires. Using D/V of 0.25 instead of D/E gives 13.5%, which is wrong because the formula needs the debt to equity ratio.

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