WACC

Question 1

How can shareholder wealth be increased through capital structure decisions?

Answer 1

By lowering the WACC (Weighted Average Cost of Capital), which increases the Market Value (MV) of the company. Debt is cheaper than equity, but increasing debt also raises financial risk and the cost of equity, potentially increasing the WACC.

Question 2

What are the three main theories addressing capital structure?

Answer 2

Traditional (Intuitive) Theory
Modigliani & Miller (M&M) – No Tax
Modigliani & Miller (M&M) – With Tax

Question 3

What does the Traditional Theory suggest about optimal gearing?

Answer 3

At lower gearing levels, WACC decreases due to cheaper debt. At higher levels, WACC rises due to increased financial risk and bankruptcy concerns. There is an optimal level of gearing that minimises WACC and maximises MV.

Question 4

What is the conclusion of M&M’s no-tax model?

Answer 4

Capital structure is irrelevant to the firm’s MV. Changes in gearing do not affect WACC because the increase in the cost of equity offsets the benefit of cheaper debt.

Question 5

How does M&M’s model change when taxes are considered?

Answer 5

Interest is tax-deductible, making debt cheaper. The cost of equity rises with gearing but not enough to offset the tax benefits of debt. The conclusion is to gear up as much as possible to minimise WACC and maximise MV.

Question 6

Why might companies avoid high levels of gearing despite M&M with tax?

Answer 6

Bankruptcy risk
Restrictive covenants
Tax exhaustion
Limited debt capacity
Managers’ risk aversion
Shareholders’ preference for portfolio diversification

Question 7

What does the Static Trade-Off Theory suggest about optimal gearing?

Answer 7

Firms aim for an optimal gearing level by balancing the benefits (tax relief) and costs (bankruptcy risk) of debt.

Question 8

What is the Pecking Order Theory’s financing hierarchy?

Answer 8

Retained earnings
Debt
Equity
This avoids issue costs, reduces time persuading investors, and minimises information asymmetry.

Question 9

What does the Pecking Order Theory imply about financing decisions?

Answer 9

Managers prefer safe, low-risk funds (retentions or low-risk debt). Companies with low retentions and high debt are less likely to invest, and financing affects project valuation.

Question 10

What are some factors influencing capital structure decisions?

Answer 10

Growth and stability of sales
Industry competition
Economic conditions
Asset availability for collateral
Cash flow projections
Management’s risk attitude
Lenders’ attitudes
Tax considerations
Asset quality