Question

MM Proposition II, without taxes, is the proposition that:

A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm.

B. a firm's cost of equity increases in direct relationship to the increase in debt.

C. the cost of levered equity is determined solely by the return on debt, the debt-equity ratio, and the tax rate.

D. the cost of equity depends on the market value of the firm's assets.

E. supports the argument that the size of the pie does not depend on how the pie is sliced.

Answer 1

Modigliani and Miller 's have proposed about capital structure of corporation

The proposition 2 states that without any taxes or costs of financial distress, the cost of equity capital increases as the percentage of debt increases in the capital structure

It can be derived using the WACC formula without taxes,

WACC = E/(E+D) * COE + D/(E+D) * COD

E/(E+D) * COE = WACC - D/(E+D) * COD

COE = WACC * (E+D)/E - D/(E+D) * COD * (E+D)/E

COE = WACC *  (E+D)/E - D/E COD

COE = WACC* (E/E + D/E) -  D/E COD

COE = WACC* E/E + WACC * D/E -  D/E * COD

COE = WACC + (WACC - COD) *  D/E

Which is directly implying that COE is proportional to D and its increases as the debt increases

Answer: B) A firm's cost of equity increases in direct relationship to the increase in debt