ACCA FM · Chapter 12 · Question 2 of 9
According to Modigliani and Miller's theory of capital structure WITHOUT taxes, what happens as a company increases its gearing?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: A) The cost of equity rises exactly enough to offset the benefit of cheaper debt, so WACC and company value are unchanged
Explanation
In a perfect market with no taxes, MM argued that the cost of equity increases linearly with gearing to compensate shareholders for extra financial risk. This exactly cancels the benefit of using cheaper debt, so WACC is constant and the value of the company depends only on its operating cash flows and business risk.
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