tailieunhanh - Lecture Investment analysis & portfolio management - Chapter 22

Modigliani and Miller revised their arguments to allow for the fact that there is tax relief on interest. You do not need to know the arguments they used to reach their conclusions, but you must know what their conclusions were. You should also know and be able to apply the formulae described below. | Investment Analysis Lecture: 22 Course Code: MBF702 1 Outline RECAP MODIGLIANI AND MILLER’S THEORY MM’s Theory with tax Modigliani and Miller revised their arguments to allow for the fact that there is tax relief on interest. You do not need to know the arguments they used to reach their conclusions, but you must know what their conclusions were. You should also know and be able to apply the formulae described below. Modigliani and Miller argued that allowing for corporate taxation and tax relief on interest, an increase in gearing will have the following effect: As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital structure of the firm. However, the cost of equity rises as gearing increases. As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of equity is that the WACC becomes lower. Increases in gearing result in a reduction in the WACC. MM’s Theory with tax The WACC is therefore at . | Investment Analysis Lecture: 22 Course Code: MBF702 1 Outline RECAP MODIGLIANI AND MILLER’S THEORY MM’s Theory with tax Modigliani and Miller revised their arguments to allow for the fact that there is tax relief on interest. You do not need to know the arguments they used to reach their conclusions, but you must know what their conclusions were. You should also know and be able to apply the formulae described below. Modigliani and Miller argued that allowing for corporate taxation and tax relief on interest, an increase in gearing will have the following effect: As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital structure of the firm. However, the cost of equity rises as gearing increases. As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of equity is that the WACC becomes lower. Increases in gearing result in a reduction in the WACC. MM’s Theory with tax The WACC is therefore at its lowest at the highest practicable level of gearing. (There are practical limitations on gearing that stop it from reaching very high levels. For example, lenders will not provide more debt capital except at a much higher cost, due to the high credit risk). The total value of the company is therefore higher for a geared company than for an identical all-equity company. The value of a company will rise, for a given level of annual cash profits before interest, as its gearing increases. Modigliani and Miller therefore reached the conclusion that because of tax relief on interest, there is an optimum level of gearing that a company should be trying to achieve. A company should be trying to make its gearing as high as possible, to the maximum practicable level, in order to maximise its value. MM’s Theory with tax MM’s Theory with tax Modigliani and Miller’s arguments, allowing taxation, can be summarised as two propositions. Proposition 1. The WACC falls continually as the level of .