Financial Strategy is one of the most tricky paper of
strategic level. It disguise as a easy calculation cum theory paper that can be
considered a piece of cake at first sight. However, the examination itself is
where the f3 jinne comes out of the bottle. Time constraint, calculation –
number crunch and the answer to be discussed in a most precise way to please
the examiner. Sweating, breathing heavily ? Well don’t need to J
Today im going to write about the most assessed topic of MM and traditional theory. Its one of the examiner’s favorite topic together with
the CAPM that I will discuss later in another blog.
Traditional theory is where the cost of equity increases as
the cost of debt increases and that increase the WACC ultimately after a
certain point known as the * optimum point* where the
WACC is the lowest . At optimum point wacc is the lowest
and value of the firm is maximum ( due to the inversely proportional
relationship between the two) . However when the debt is taken too much with
high cost of debt it will increase financial risk and Ke. Automatically
accelerating Wacc thereby minimizing the value of firm.
MM theory has two assumptions one is with tax and the other
is without tax . It has the assumption that a firm that is identical in all
respect apart from capital structure should have the same value.
MM without tax has
Wacc remaining as a constant. The cost of debt remains constant until it
increases. It can be explained that cost of debt is taken as Rf ( risk free
rate) hence its constant. However the increase in gearing will increase the
risk perceived by debt holders ( kd) so Kd increases after a certain point. There
is consequently a fall in Ke ( cost of
equity) as more investors come to get
high return on equity.
MM with tax on the other hand is where the tax element in
the cost of debt is taken into account with Kd( 1-t) being tax deductible. MM
with tax assumes that debt lowers the Wacc due to its lower issue cost and with
tax saved on it. The Ke however increases
due to the high financial risk with high debt taken.
This is what MM and traditional model theory is all about
and in F3 candidates are often asked to explain it, differentiate between it
and numerical questions that comes are also based on it.
PS:
This question#04 on MM is self fullfilling to understand the concept further. It is also advised that the diagram is to be practiced for further understanding and ease for remembering purpose
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