I hope that you?re reading these Answers in the order that they were
answered because the last question on Joe?s Manufacturing is critical
to answering this one:
According to Proposition 2 of the M&M theorem, the value of the firm
stays the same and costs of capital shift, as follows:
rE = r0 + D/E*(1-Tc)*(r0 - rD)
rE is the cost of equity
rD is the cost of debt
r0 is the cost of capital for an all-equity firm
D is the debt level
E is the equity level
Tc is the corporate tax rate
rWACC is a firm?s weighted average cost of capital. In a world with no
taxes, rWACC for a levered firm is equal to rA.
?M&M Proposition II,? (Harvey, Dec. 4, 1995)
JOE?S WITH DEBT
Here?s what we know about Joe?s Manufacturing:
14.34% = r0 + $750/$1,250 * (0.65) * (r0 ? 6%)
14.34% = r0 + 0.39r0 ? 2.34%
16.68% = 1.39 r0
r0 = 12%
What?s important to remember here?
1. the value of the firm stays the same.
2. your capital costs shift ? the cost of equity goes up because debt
is increasing the risk to shareholders (bond holders always get paid
first). Also, the weighted-average cost-of-capital (WACC) goes down/
3. the tax-deductibility of debt further reduces the WACC.
Google search strategy:
?Modigliani-Miller? proposition II