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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Under MM Proposition II without taxes, an all-equity firm, Kaveri Industries, has a cost of equity of 12%. It restructures to a debt-to-equity ratio (D/E) of 0.5 at market values, with a cost of debt of 8%. What is the new cost of equity?

The new cost of equity is 14%. MM Proposition II gives Ke = K0 + (K0 - Kd) x D/E, so 12% + 4% x 0.5 = 14%. The higher financial risk to shareholders offsets the cheaper debt so WACC remains 12%.

  1. A12%
  2. B14%
  3. C13%Correct
  4. D16%
  5. 10%

Explanation

Ke = K0 + (K0 - Kd) x D/E = 12% + (12% - 8%) x 0.5 = 14%. Check via WACC: weights E = 2/3 and D = 1/3, giving 0.6667 x 14% + 0.3333 x 8% = 12%, which equals K0. The 13% option wrongly uses D/(D+E) = 1/3 rather than D/E, giving 12% + 4% x 1/3 = 13.33%, which is also not 13%.

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