Theories of Gearing Flashcards
What does the traditional theory of gearing conclude?
That there is an optimal level of gearing
The tradition theory of gearing ignores what?
Tax
In the traditional theory of gearing, at low levels of gearing, Ke may … but debt is….. so WACC will…..
Rise
Cheaper
Fall
In the traditional theory, how will a high gearing affect Financial Risk?
It will increase
In the traditional theory, how will a high gearing affect Ke, and what impact will this have on the WACC?
Ke will rise, outweighing the benefit of cheaper debt, and increasing the WACC
What is a major problem with the theory of gearing?
There is no method - it’s trial and error
M&M’s theory without Tax is based on what assumption?
That investors are rational.
Their required return is directly proportional to the increasing in gearing, therefore having no impact on the WACC.
In M&M’s theory of gearing, how does the assumption of the linear relationship between the required return, and increase in gearing work?
The benefit of cheaper debt offsets the increase cost of equity - therefore having no effect on the WACC
What are the assumptions of M&M’s theory without tax?
- No tax
- There’s a perfect market
- No transaction costs
- Debt is risk free
M&M modified their theory to reflect what?
Tax relief on interest payments
Debt interest in M&M with Tax is lower than in M&M without tax. Why?
Debt interest is tax deductible
In M&M with tax - Lower debt costs results in less volatility in returns for the same level of gearing. This mean Ke has a _________
lower increase
In M&M with tax Increase in Ke does not offset the benefit of cheaper debt. What happens to the WACC as a result?
It falls as gearing increases
According to M&M’s theory with tax, what is optimal structure -
99.9% gearing.
