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ACCA Strategic Professional · Strategic Business Leader · Financial analysis and decision-making techniques

Harbour Tech, a fast-growing listed software firm, has little collateral, volatile profits and high growth opportunities. Its chair argues the company should switch to very high gearing because debt is cheaper than equity and WACC will therefore fall continuously. Based on the trade-off view of capital structure, which response is most appropriate?

The chair's claim should be rejected. The trade-off view says the debt tax shield is eventually outweighed by financial distress and agency costs. With volatile profits and little collateral, Harbour Tech would reach that point at modest gearing, so WACC would not keep falling and an optimal structure exists.

  1. AAgree, because under the trade-off view each extra unit of debt always reduces WACC due to the tax shield
  2. BDisagree, because tax relief on interest is outweighed beyond a point by rising financial distress and agency costs, which are especially significant for a firm with volatile profits and few tangible assetsCorrect
  3. CAgree, because the cost of equity is independent of gearing in the real world
  4. DDisagree, because debt can never be cheaper than equity once tax is considered

Explanation

The trade-off theory balances the tax shield on debt against expected costs of financial distress and agency costs. Volatile profits and weak collateral raise those costs early, so an optimal gearing level exists below very high debt. Option 1 describes the Modigliani-Miller with-tax proposition without distress costs, and debt is usually cheaper than equity.

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