In: Accounting
Norman Plc has the following sources of long-term capital:
Required:
c. Discuss the theory of Modigliani and Miller in relation to WACC in a world with no tax compared to their later theory where tax is acknowledged. (You may find the use of diagrams could help illustrate your discussion).
A) Cost of Equity = Expected Dividend/Market Price of Equity
=0.30+5%/3.50*100
=9%
Cost of irredemable Preference Share = Preference Dividend/Net proceeds on issue of preference share
=0.38/0.92*100
=41.30%
Cost of Irredemable Debentures = Interest(1-Tax Rate)/Market Price
=9(1-0.25)/80
=8.44%
B)
Capital Component | Market Value | Cost Of Capital | % of Total capital Structure | Total |
Ordinary Shares | 70000000 | 9 | 0.68 | 6.12 |
Prefrence Shares | 7360000 | 41.3 | 0.07 | 2.95 |
Debentures | 25600000 | 8.44 | 0.25 | 2.10 |
102960000 | WACC | 11.17 |
C) The Modigliani and Miller approach assumes that there are no taxes. But in real world this is far from truth.MOst countries,if not all, tax a company. This theory recognises the tax benefit accrued by ingterest payments. The onterest paid on borrowed funds is tax deductible. However same is not the case with dividends paid on equity. To put in other words, the actual cost of debt is less than the nominal cost of debt necause of tax benefits. The trade-off theory advocates that a company can capitilise its requirements with debts as long as the cost of debt i.e. the cost of bankruptcy exceeds the value of tax beneits. Thus the increased debts, until a given threshold value will add value to a company.
This approach with corporate tax does acknowledge tax savings and thus infers that a changein debt equity ratio has an effect on WACC. This means higher the debt, higher is the WACC.