ACCA Financial Management (F9) Certification Practice Exam

How does tax relief on interest payments affect a company's WACC, as per Modigliani and Miller's theory?

1. It has no effect

2. It decreases WACC by providing a tax shield

3. It increases WACC due to more debt

4. It only affects equity costs

The correct answer is: It decreases WACC by providing a tax shield

Tax relief on interest payments is significant when analyzing a company's Weighted Average Cost of Capital (WACC) under Modigliani and Miller's theory, particularly in the presence of corporate taxes. The statement that tax relief decreases WACC by providing a tax shield is accurate. When a company incurs debt, the interest payments on that debt are typically tax-deductible. This creates a tax shield, reducing the company’s taxable income and, consequently, its tax burden. The reduction in taxes effectively lowers the cost of debt because the company pays less in taxes when it has interest expenses. As a result, the overall WACC declines because the after-tax cost of debt is lower than the nominal cost of debt. This leads to a situation where companies benefit from leveraging their capital structure with debt, making the overall capital cost cheaper. WACC is a weighted average of the costs of equity and debt, and when the cost of debt decreases due to the tax shield, it effectively pulls the WACC lower. In contrast, statements such as the notion that it has no effect or that it increases WACC due to more debt misinterpret the relationship between debt financing and tax impact. While increasing debt does introduce financial risk, the immediate effect of tax relief from interest