ACCA Financial Management (F9) Certification Practice Exam

What impact does a company's capital structure have on WACC in the absence of tax relief on debt interest, according to Modigliani and Miller's theory?

1. It increases WACC

2. It reduces WACC

3. It remains unimpacted

4. It varies with equity issued

The correct answer is: It remains unimpacted

According to Modigliani and Miller's theory, specifically in a situation where corporate taxes are not considered, the capital structure of a company does not affect its weighted average cost of capital (WACC). This is because the theory posits that, under these ideal conditions, the cost of equity rises with the level of debt, perfectly offsetting the lower cost of debt in a way that the overall cost of capital remains constant regardless of how a company finances its operations, either through debt or equity. In the absence of taxes, as a company increases its debt, while the cost of debt is lower compared to equity, the increased risk associated with higher debt levels causes the required return on equity to rise. Therefore, the gains from using cheaper debt capital are exactly countered by the rising cost of equity, resulting in no overall change in WACC. This principle illustrates the irrelevance of capital structure in a world without taxes, leading to the conclusion that the WACC remains unimpacted as long as other conditions set by the theory are met.