Page 40 - 5.2 i. Manac Finance ITC Summarised Notes
P. 40
COST OF CAPITAL
Cost of Capital Theories
The Traditional Theory:
• This theory assumes that an optimal capital structure exists and the cost of capital (WACC) is
dependant on the capital structure.
• NB: The optimal capital structure will be where the company minimises its WACC (as this is
where the company value is maximised).
The Miller and Modigliani (Irrelevancy) Theory:
• This theory assumes that there is no optimal capital structure and that the cost of capital
(WACC) is independent of the capital structure.
• A firm should be indifferent as to whether it is funded by debt or equity and the value of a
company is determined by its assets and not the manner in which those assets are financed.
• The Miller and Modigliani Theory makes a lot of assumptions which are not realistic and would
seldom apply to South Africa as the traditional theory more closely resembles the real world.
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