ACCA · Question 17.2 · Business Finance
CASE 2: AERODRONE TECH
AeroDrone Tech is an ungeared manufacturer of commercial delivery drones. The company currently has a cost of equity of 12%. The board is considering a major restructuring to issue debt and repurchase equity. The corporate tax rate is 25%. The risk-free rate is 4% and the equity risk premium is 6%.
According to Modigliani and Miller's theory with corporate taxes, what will be the impact of issuing debt on AeroDrone's Weighted Average Cost of Capital (WACC) and market value?
Answer options:
WACC will remain constant and market value will remain constant.
WACC will decrease and market value will increase up to an optimal point, after which bankruptcy costs outweigh tax shields.
WACC will decrease and market value will increase up to a gearing level of 99.9%.
WACC will increase because equity holders will demand higher returns due to financial risk.
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