Question

In perfect market, cost of equity(rE) = 16.31% and WACC = 14.80%

However, when the corporate tax exist WACC = 14.78%

Use MM theory to explain the effect of capital structure on the equity cost of capital and WACC a) in perfect markets, and b) when corporate tax exists.

Answer 1

As per Theory

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

• There are no taxes.
• Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant bankers, advertisement expenses, etc.
• There is no corporate dividend tax.

Explaining the effect of capital structure on the equity cost of capital and WACC.

a) in perfect market

It says that financial leverage is in direct proportion to the cost of equity. With an increase in the debt component, the equity shareholders perceive a higher risk to the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. It implies that component cost of capital (i.e. cost of debt and cost of equity) will adjust with any change in debt to equity ratio resulting in a constant weighted-average cost of capital.

Therefore, under perfect market situation , there will be increase in Cost of Equity but there will be no impact on WACC.

b) when corporate tax exists.

The Modigliani and Miller Approach assumes that there are no taxes, but in the real world, this is far from the truth. Most countries, if not all, tax companies. This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible.In other words, the actual cost of debt is less than the nominal cost of debt due to tax benefits. This means that the higher the debt, the lower the WACC. Existence of taxes creates a preference for debt resulting in a lower increase in equity with addition of debt

Therefore, when corporate tax exists, there will be increase in Cost of Equity but at decreasing Rate and also there will be decline in WACC.

Showing Calculations

Using MM Theory, explaining the effect of capital structure on the equity cost of capital and WACC.

Following formula is used under MM Theory

k_e = WACC + (WACC − k_d)

where k_e = Cost of Equity

WACC = Weighted Average Cost of Capital

k_d = Cost of Debt

As the Cost of Capital of any company comprises of Equity and Debt.

a) in perfect market

k_e = WACC + (WACC − k_d)

0.1631 = 0.148 + (0.148 - k_d)

0.1631 = 0.296 - k_d

k_d = 0.1329 i.e 13.29 %

b) when corporate tax exists.

k_e = WACC + (WACC − k_d)

k_e = 0.1478 + (0.1478 - 0.1329)

k_e = 0.1329 i.e 16.27%

AS we can see, when corporate tax exist, the equity cost of capital decreases from 16.31% to 16.27%. and also there is decrease in WACC from 14.80% to 14.78% as tax expense being in nature of Cost.