payments were an allowable expense in calculating taxable profit and so the effective cost of debt was reduced by its tax
efficiency. They revised their model to include this tax effect and showed that, as a result, the WACC decreased in a linear
fashion as a company geared up. The value of the company increased by the value of the ‘tax shield’ and an optimal capital
structure would result by gearing up as much as possible.
It was pointed out that market imperfections associated with high levels of gearing, such as bankruptcy risk and agency costs,
would limit the extent to which a company could gear up. In practice, therefore, it appears that companies can reduce their
WACC by increasing gearing, while avoiding the financial distress that can arise at high levels of gearing.
Time allowed
Reading and planning: 15 minutes
Writing: 3 hours a
ALL FOUR questions are compulsory and MUST be attempted.
Formulae Sheet, Present Value and Annuity Tables are on
pages 6, 7 and 8.
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During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
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The Association of Chartered Certified Accountants
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