wacc query

[johnpe21]

Hi. I am a bit confused with the wacc concept and more specifically with what MM claims. Is it true that no matter how much gearing changes, wacc will be the same? For example, in page 13, in the diagram, do will the wacc points on the left and on the right be the same in the end?

Thanks a lot !

 

[johnpe21]

anyone?

 

[Colin McKee]

Wacc

Hi, Sorry for the late reply. I didnt get an email letting me know there was a post. There are two answers to your question. The first in teh ideal world (M&M) with no taxes and expenses. In this world, increasing gearing does not affect WACC. It introduces more low-cost debt into the capital structure, but increases the cost of the equity capital. the net result is - no gain. However in a taxed world, debt reduces the amount that the tax man takes out of a company, and therefore increases effiency of the company. WACC will decrease as gearing increases. In theory it will increase indefinitley until the cost of capital is approaching the after-tax cost of debt. But in reality as gearing gets to extreme levels, there is a panic factor. Cost of equity rises shrply and cost of debt rises shrply and the result offsets any benefit that the tax saving may bring. So the WACC actually starts to rise again.
As for the diagram on PG13, it is only approximate. there is no link between the far right and the far left. they are only the same level because of the limits of Microsoft Word!. there is nohard and fast rule as it relies on the human panic factor and will vary from one instance to the next and between different types of company.