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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Ganga Steels Ltd has an unlevered cost of equity of 12%, pre-tax cost of debt of 8% and a tax rate of 25%. Its target capital structure has debt-equity ratio of 1:2 (market values). Using the Modigliani-Miller proposition with corporate taxes, what is the cost of equity of the levered firm?

The levered cost of equity is 13.5%. Under Modigliani-Miller with taxes, it equals 12% plus the 4% spread times (1 minus 25%) times the debt-equity ratio of 0.5, which adds 1.5 percentage points to the unlevered cost.

  1. A13.5%Correct
  2. B14.0%
  3. C15.0%
  4. D13.0%

Explanation

ke = ku + (ku − kd)(1 − t)(D/E) = 12 + (12 − 8)(0.75)(0.5) = 12 + 1.5 = 13.5%. Check: weights E 2/3, D 1/3 give WACC = 13.5×2/3 + 8×0.75×1/3 = 9 + 2 = 11%, equal to ku(1 − tD/V) = 12 × (1 − 0.25/3) = 11%. Ignoring tax gives 14%, which is wrong.

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