ACCA FM · Chapter 12 · Question 4 of 9
Using Modigliani and Miller's theory with tax, an ungeared company has a cost of equity of 11%. A geared company in the same business risk class has debt to equity of 40:60 (market values) and a pre-tax cost of debt of 6%. The tax rate is 25%. What is the geared company's cost of equity?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: C) 13.5%
Explanation
Keg = Keu + (1 - T)(Keu - Kd) x Vd/Ve = 11% + 0.75 x (11% - 6%) x 40/60 = 11% + 0.75 x 5% x 0.6667 = 13.5%. Omitting the tax adjustment gives 14.33% (the MM no-tax result), and using debt to total value instead of debt to equity gives 12.5%.
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