Hi, The first point on the ASET mark scheme for Q6(i)(b) states. By using debt can gear up the returns that the US company produces... does gearing up just mean that we are borrowing against future returns? ...assuming profits from the US company can service the interest payments. Is this important because otherwise we are not gearing up the US returns but in fact are just gearing up European returns and introducing currency risk? Also, the point by using debt we may reduce WACC - is this assuming cost of debt < cost of equity? Thank you.
Yes, when a company increases debt rather than issue equity, any profits above the debt interest will fall to the existing equity shareholders "gearing up" the returns to shareholders. (It works on the way down too, when profits fall). If the US profits cover the interest then it means that there is less chance of the debt leading to bankruptcy. Debt reduces WACC mainly because it reduces profits before tax which reduces the tax that a company pays on profits. Although debt is cheaper, Modigliani & Miller suggest that the cheap debt is offset by an increase in the cost of equity, leading to no "net" gain in the average cost of capital. But it does reduce the tax charge.
