Page 167 - Microsoft Word - 00 CIMA F1 Prelims STUDENT 2018.docx
P. 167
Financing – Capital structure
3.6 The M & M formulae
Value of the company (D+E): V g = V u + TB
The value of a geared entity is the value of the equivalent ungeared
entity, plus the value of the tax shield on debt.
Cost of equity: k eg = k eu + (k eu – k d)[V D(1–t)/V E)]
The cost of equity rises in a linear manner as gearing increases (as
shown on the graphs above).
WACC: WACC = k eu [1–V D t/(V D + V E)]
The WACC falls (from Keu at a zero gearing level) as gearing
increases.
where:
V = Value of company (V g = geared company, V u = ungeared company)
k e = Cost of equity (k eg = geared company, k eu = ungeared company)
k d = Cost of debt (gross of tax)
B,V D = MV of debt
V E = MV of geared company's equity
T, t = Corporate income tax rate
TB = ‘the present value of the tax shield’
159
