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

Which of the following is a practical reason why a company might not pursue the very high gearing suggested by Modigliani and Miller's theory with tax?

Companies avoid very high gearing because greater debt raises the probability and cost of financial distress and bankruptcy, along with agency costs and covenants. These costs eventually outweigh the tax shield benefit, so an optimal gearing level exists below 100% debt.

  1. AInterest on debt is not tax deductible in most countries
  2. BHigher gearing increases bankruptcy costs and financial distress risk, which offset tax benefitsCorrect
  3. CEquity is always cheaper than debt
  4. DShareholders are indifferent to financial risk

Explanation

In practice, as gearing rises, the risk of financial distress, bankruptcy costs, agency costs and restrictive covenants increase, offsetting the tax shield and leading to an optimal gearing level. Interest is usually tax deductible, and debt is normally cheaper than equity.

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