1. M&M Proposition II Without taxes & bankruptcy costs
Lecture 17
M&M Proposition II
Without taxes & bankruptcy costs

2. Topics covered The proposition The formula The graph The implications
Numerical example
Practice problem

3. M&M Proposition II Assumptions: Perfect market No taxes
No bankruptcy costs
M&M Proposition II:
1. A firm’s cost of equity depends on 3 factors: its weighted average cost of capital, cost of debt, and debt-equity ratio.
2. A firm’s weight average cost of capital will remain constant no matter what its debt-equity financing mix.

4. The Formula
RE = RA + [(RA – RD) x (D/E)] RE = required rate of return on equity (cost of equity) RA = required rate of return on firm’s assets RD = required rate of return on debt D = market value of debt E = market value of equity D/E = market value debt-equity ratio

5. The Graph
Required rate of return RE RA WACC RD D/E ratio

6. The Implications The cost of equity is determined by 3 factors:
Cost of capital of the firm (WACC = RA)
Cost of debt (RD)
Debt-equity split (D/E)
A firm’s cost of equity rises as financial leverage increases.
A firm’s WACC is independent of changes in its capital structure.

7. Numerical Example
Millets and Multigrain Inc. has a weighted average cost of capital of 15%. It is currently financed entirely with common stock. Its current share price is $20, with 100,000 shares outstanding. The company’s managers is contemplating a bond issue of $1.2 million at 10% interest rate. The cash received from the bond issue will be used to repurchase 60,000 of the firm’s common shares. After the repurchase, the share price will remain at $20.
According to the M&M Proposition II without taxes and bankruptcy costs,
What is the cost of equity for the firm?
What will be its WACC after the debt issue?

8. Numerical Example (cont.): Calculation of RE

9. Numerical Example (cont.): Calculation of WACC

10. Less Talk, More Practice
HST n’ BC Inc. is financed by debt of $2 million and equity of $2 million. The company’s cost of debt is 8% and its weighted cost of capital is 16%. What is the company’s current cost of equity? What is the impact on the cost of equity if the company wants to change its debt-equity ratio to 0? 0.5? 1.5? 2? 2.5?

11. Check answer to practice problem
We first write out the information given: D = $2,000,000 E = $2,000,000 RD = 0.08 WACC = RA = 0.16 The debt-equity ratio is: D/E = 2,000,000 / 2,000,000 = 1 M&M Proposition II without taxes and bankruptcy costs gives us the cost of equity formula: RE = RA + [(RA – RD) x (D/E)] Plugging in the numbers for RA, RD, and D/E, we get RE = [(0.16 – 0.08) x 1] = = 0.24 If the D/E = 0, we have RE = [(0.16 – 0.08) x 0] = = 0.16
If the D/E = 0.5, we have RE = [(0.16 – 0.08) x 0.5] = = 0.2 If the D/E = 1.5, we have RE = [(0.16 – 0.08) x 1.5] = = 0.28 If the D/E = 2, we have RE = [(0.16 – 0.08) x 2] = = 0.32

12. End of Lecture 16