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

Which statement about Modigliani and Miller's capital structure theory with corporate taxes is correct?

With corporate taxes, Modigliani and Miller show a geared company is worth more than an equivalent ungeared one by the present value of the tax shield on debt interest. WACC falls as gearing increases, whereas the no-tax version says gearing is irrelevant.

  1. AThe cost of equity falls as gearing rises, so WACC is unchanged
  2. BThe value of a geared company exceeds that of an equivalent ungeared company by the present value of the tax shield on debt interestCorrect
  3. CThe WACC rises as gearing increases because debt is riskier than equity
  4. DGearing has no effect on company value because investors can create their own gearing

Explanation

With corporate tax, MM show that debt interest is tax deductible, so the geared company's value equals the ungeared value plus the present value of the tax shield (Dt for irredeemable debt). WACC therefore falls as gearing rises. The no-effect option describes MM without tax.

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