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CFA Level I · CFA Level I Exam · Capital Structure

Under Modigliani-Miller Proposition II without taxes, as a firm increases its debt-to-equity ratio, the cost of equity most likely:

The cost of equity rises linearly with the debt-to-equity ratio. Proposition II says equity holders demand a higher return as leverage increases their financial risk, which exactly offsets cheaper debt and leaves WACC unchanged.

  1. AFalls, offsetting the higher cost of debt
  2. BRises linearly with the debt-to-equity ratioCorrect
  3. CStays constant because the WACC is constant

Explanation

Proposition II gives re = r0 + (r0 − rd)(D/E), so the cost of equity rises linearly with leverage as shareholders bear more financial risk. This keeps WACC constant. The constant-cost-of-equity option confuses the constant WACC with the cost of equity.

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