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

Under Modigliani and Miller's capital structure theory with corporate tax (1963), which statement about the effect of introducing debt is correct, assuming no other market imperfections?

With corporate tax, a geared company is worth more than an identical ungeared one, by the present value of the tax saved on interest. Interest is tax deductible, so the tax shield adds value, and WACC falls as gearing rises.

  1. AThe value of the geared company exceeds that of an equivalent ungeared company by the present value of the tax shield on debt interestCorrect
  2. BThe value of the geared company is unchanged because tax relief is offset by a higher cost of equity
  3. CThe value of the geared company falls because interest payments reduce cash available to shareholders
  4. DThe weighted average cost of capital rises as gearing increases because debt is riskier than equity

Explanation

With corporate tax, interest is deductible, creating a tax shield. Value of geared company = value of ungeared company + tax shield on debt (Dt for permanent debt). Option B describes the no-tax proposition. WACC falls, not rises, as gearing increases with tax.

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