Question

Within the Modigliani Miller framework, under Scenario I (with no frictional costs, no taxes, and no financial distress), consider a firm with $40 million in cash flows, initially all equity financed, and the cost of equity is 13%. If the firm takes on new debt of $150 million, with a 9% interest rate, what is the new Re or cost of equity for the firm?

Select one:

a. 13%

b. just over 16%

c. 18.4%

d. 26.5%

e. just under 13%

Answer 1

Correct answer: b. just over 16%

Under Modigiliani Miller proposition -2 (without taxes). Cost of equity of levered firm (Re) can be computed with following equation.

where,

Re = Cost of equity levered firm

Ra = Dost of equity unlevered firm

Rd = Cost of debt

D = Debt

E = equity

Firstly, Calculate the value of Equity and Debt in levered firm.

Provided,

Cash Flow of Firm = $40 million

Cost of capital (unlevered) (Ra) = 13%

thus,

Value of unlevered firm = $305.69

M&M Proposition-1 (without tax) suggest that capital structure of firm does effect the value of firm.

Thus,

Value of firm after debt issue (i.e levered) remain same.

Debt issued (D) = $150 million,

Putting the values, in Re equation,

by solving,

Thus, Cost of equity (levered) is just over 16%.