Question

Apple is domiciled in a country where interest payments are not tax deductible. Bankruptcy proceedings in this country are primitive, and bankruptcy would be a costly event for Apple.

Otherwise, there are no other significant departures from the assumptions of the Modigliani-Miller theorem (perfect information, no financial frictions, etc.).

Which of these answers are right?

Apple should be financed entirely by debt.

Apple should be financed entirely by equity.

Apple should be financed by both debt and equity.

Answer 1

Factors for consideration are:

1. When a firm's interest payments are not tax deductible, debt financing is a more costly option. So increasing debt financing for a lower WACC would not work in this case.

2. Dividend payments to equity shareholders are discretionary in nature and are paid only after the debt financing is serviced.

For a firm like Apple, debt and equity financing are both equally costly and it is unable to take advantage of the tax benefits associated with debt. Debt would also be associated with bankruptcy risk.

So given the scenario Apple should go for an all equity financing.