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%.**

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