Effect of Changes in Gearing OT Flashcards
Increase gearing of company? (Traditional theory)
Cost of equity goes up as more risk to shareholders
Cost of debt is constant as risk free unless too high thereby it increases
What is the optimal evel of gearing?
Where WACC is the minimum.
Optimal level achieved next steps
Finance should be raised to ensure gearing is the same
More debt means?
More fixed interest
Miller and Mod theory increase in gearing?
Cost of equity goes up in a very precise way, cost of debt is the same until too high. WACC remains constant no matter the gearing
If WACC remains the same?
Optimal level is irrelevant, how business raises finace is irrelevant
Issue with Miller and Mod?
It ignores tax
Are dividends tax allowable?
No. Therefore no effect on equity
Tax effect on debt?
Makes debt lower
Mod and Miller with tax theory increase in gearing?
Cost of equity increases gradually. Cost of debt remains constant but smaller amount compared to no tax. WACC decreases unless very high level of gearing
Mod and Miller with tax theory assumption?
The higher gearing the better
When debt finance better than equity
The tax benefit of debt interest
Perfect knowledge and dividends?
Shareholders know what the dividend will be and have all the information
Are transaction costs ignored in a perfect market?
Yes
What does perfect market assume?
Irredeemable debt, but in reality it is most likely redeemable
