CA Inter P6 · Chapter 5 · Question 6 of 9
Under Modigliani-Miller Proposition II (no taxes), a firm has an overall cost of capital of 12%, a cost of debt of 8% and a debt-equity ratio of 0.5. Its cost of equity is:
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: C) 14%
Explanation
MM Proposition II states that Ke = Ko + (Ko - Kd) x D/E = 12% + (12% - 8%) x 0.5 = 12% + 2% = 14%. The cost of equity rises in line with leverage to exactly offset the benefit of cheaper debt, so Ko stays at 12%.
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