CFA Level I · CFA Level I Exam · Capital Structure
An unlevered firm has a cost of equity of 10%. It issues debt and repurchases shares to reach a debt-to-equity ratio of 0.50, with debt costing 6%. Assuming Modigliani-Miller Proposition II with no taxes, the cost of equity of the levered firm is closest to:
The levered cost of equity is about 12.0%. Using Proposition II, add the unlevered cost of 10% to the spread over debt of 4% multiplied by a debt-to-equity ratio of 0.50, giving 12%. The WACC then remains 10%.
- A10.0%
- B12.0%Correct
- C13.0%
Explanation
re = r0 + (r0 − rd)(D/E) = 10% + (10% − 6%)(0.50) = 12%. Check: D/V=1/3, E/V=2/3, WACC = (1/3)(6%)+(2/3)(12%)=10%, which equals r0. Choosing 13% uses a wrong spread, and 10% ignores leverage.
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