ACCA · Question 25 · Business Finance
Section B - Case 2: NeuroLink Prosthetics
Scenario: NeuroLink Prosthetics is a MedTech firm. It has 10 million ordinary shares in issue, currently trading at $4.50 per share. The company's equity beta is 1.2. The risk-free rate of return is 4% and the expected return on the market portfolio is 10%. NeuroLink also has $15 million (nominal value) of 6% redeemable bonds, currently trading at $95 per $100 nominal, redeemable at par in 5 years. The corporate tax rate is 25%.
Question: According to Modigliani and Miller's theory of capital structure WITH taxes, what happens to the WACC as a company increases its gearing (debt levels)?
Answer options:
WACC remains constant regardless of the level of gearing.
WACC continuously decreases because the tax shield on debt makes it cheaper than equity.
WACC decreases initially but then increases as bankruptcy costs outweigh the tax shield.
WACC continuously increases because higher debt increases financial risk and the cost of equity.
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