CFA Level II ExamCorporate IssuersEasy
A financial manager is evaluating the impact of increasing leverage on a company's weighted average cost of capital (WACC). The company operates in an environment with corporate taxes. According to Modigliani-Miller (MM) Proposition I with corporate taxes, as leverage increases, what is the expected impact on the company's WACC?
- AWACC remains constant.
- BWACC initially decreases, then increases.
- CWACC decreases.
- DWACC increases.
Show answer & explanationAnswer & explanation
Correct answer: C. WACC decreases.
According to Modigliani-Miller Proposition I with corporate taxes, the value of a leveraged firm is greater than that of an unleveraged firm due to the tax shield on interest payments. This increase in firm value implies a lower WACC for the leveraged firm compared to the unleveraged firm, and WACC generally decreases as leverage increases (up to the point where financial distress costs become significant, which MM I with taxes doesn't explicitly consider).
Why the other options are wrong
- A. This is true for MM Proposition I *without* taxes.
- B. This describes the static trade-off theory, not pure MM Proposition I with taxes.
- D. This is incorrect; the tax shield reduces the effective cost of debt.
MM Prop I with Taxes (WACC)
Modigliani-Miller Proposition I with corporate taxes states that WACC decreases as leverage increases due to the tax deductibility of interest payments.
- VL = VU + tD (Value of Leveraged firm = Value of Unleveraged firm + Tax * Debt)
- The tax shield makes debt cheaper than equity.
- As debt increases, the proportion of cheaper financing increases, lowering WACC.
Memory trick: Taxes Trim WACC's Total.