Economics · Corporate Finance
Which of the following statements correctly describes the relationship between gearing and the Weighted Average Cost of Capital (WACC) according to Modigliani and Miller's (M&M) theory with corporate tax?
Verified Solution4 OptionsUpdated: October 2026👁️1 View
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- 1The WACC increases as gearing increases because the additional financial risk premium demanded by shareholders exceeds the savings from using lower-cost debt.
- 2The WACC follows a U-shaped curve, initially falling as debt is introduced but eventually rising due to increased bankruptcy risk.
- 3The WACC decreases as gearing increases because the tax-deductibility of interest makes debt cheaper, outweighing the rise in the cost of equity.✓
- 4The WACC remains constant at all levels of gearing because the benefit of cheaper debt is exactly offset by the increase in the cost of equity.
Correct answer
The WACC decreases as gearing increases because the tax-deductibility of interest makes debt cheaper, outweighing the rise in the cost of equity.
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