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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Kelvar Ltd is all-equity financed with a cost of equity of 12% and no taxes. It plans to restructure by issuing debt at 6% to repurchase shares so that debt:equity becomes 1:2 by market value. Under Modigliani and Miller (no taxes), what is the cost of equity after the restructuring?

The cost of equity rises to 15%. Under Modigliani and Miller without tax, ke equals k0 plus (k0 minus kd) times D/E, so 12% plus 6% times 0.5 equals 15%. Overall WACC stays at 12%.

  1. A14.0%Correct
  2. B12.0%
  3. C15.0%
  4. D13.0%

Explanation

MM without tax: ke = k0 + (k0 - kd) x D/E = 12% + (12% - 6%) x 0.5 = 15%? Check: D/E = 1/2 = 0.5, so 6% x 0.5 = 3%, giving 15%. Hence the correct value is 15%, and 14% would come from using the wrong gearing ratio.

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