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

Which of the following is a limitation of Modigliani and Miller's theory with corporate tax when applied in practice?

The theory ignores bankruptcy and financial distress costs, so it implies companies should be almost entirely debt financed. In practice these costs, plus agency costs and rising borrowing rates, mean an optimal gearing level exists below 100%.

  1. AIt assumes interest on debt is not tax deductible
  2. BIt ignores the costs of financial distress and bankruptcy, which suggest 100% debt is not optimalCorrect
  3. CIt assumes companies cannot borrow at the same rate as individuals
  4. DIt assumes the cost of debt rises steeply at all levels of gearing

Explanation

The theory implies maximum value at nearly 100% debt, but in practice financial distress, agency costs and rising borrowing costs limit gearing. Option A is contrary to the theory, and C is a no-tax-model assumption reversed (it assumes equal borrowing rates).

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