Medium2 marksMultiple Choice

Estimating the Cost of CapitalCost of capitalCapital structureModigliani-MillerSection B

This question is part of a case study — click to read the full scenario(Case 21)

Section B - Case 2: Helios Co

Helios Co operates wind farms across Europe. It is looking to acquire a smaller competitor, Aura Ltd. To assess the acquisition, Helios needs to calculate its own Weighted Average Cost of Capital (WACC) and value Aura Ltd.

Helios Co Data:
Current share price: $4.50
Recent dividend paid (D0): $0.30
Historical dividends:
4 years ago: $0.24
3 years ago: $0.25
2 years ago: $0.27
1 year ago: $0.28

Using the historical dividend growth rate, what is Helios Co's estimated Cost of Equity (Ke) using the Dividend Valuation Model?

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ACCA · Question 25 · Estimating the Cost of Capital

Section B - Case 2: Helios Co

To fund the acquisition, Helios Co plans to issue a significant amount of new debt, changing its capital structure.

According to Modigliani and Miller's theory with corporate taxes, what will be the impact of this increased gearing on Helios Co's WACC and Firm Value?

Answer options:

WACC will remain constant and Firm Value will remain constant.

WACC will increase and Firm Value will decrease due to higher financial risk.

WACC will decrease and Firm Value will increase due to the tax shield on debt.

WACC will decrease initially but then increase as bankruptcy costs outweigh the tax shield.

How to approach this question

Recall Modigliani and Miller's 1963 proposition (with taxes). They concluded that debt is always cheaper due to the tax deductibility of interest.

Full Answer

C.WACC will decrease and Firm Value will increase due to the tax shield on debt.✓ Correct

Modigliani and Miller's theory WITH corporate taxes states that because interest payments are tax-deductible, debt provides a 'tax shield'. As a company increases its gearing (debt), the WACC continuously falls, and the total value of the firm continuously rises. They concluded that a company should theoretically be 99.9% debt-financed. (Note: Option D describes the Trade-off theory, which is more realistic but not what M&M proposed).

Common mistakes

Selecting Option D. While Option D is how the real world works (Trade-off theory), the question specifically asks for M&M's theory with taxes.

Question 24 All questions Question 26

Practice the full ACCA FM — Financial Management Practice Exam 2

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Section B - Case 2: Helios Co To fund the acquisition, Helios Co plans to issue a significant amount of new debt, changing its capital structure. According to Modigliani and Miller's theory with corporate taxes, what will be the impact of this increased gearing on Helios Co's WACC and Firm Value?

How to approach this question

Full Answer

Common mistakes

Practice the full ACCA FM — Financial Management Practice Exam 2

More questions from this exam

Section B - Case 2: Helios Co

To fund the acquisition, Helios Co plans to issue a significant amount of new debt, changing its capital structure.

According to Modigliani and Miller's theory with corporate taxes, what will be the impact of this increased gearing on Helios Co's WACC and Firm Value?