CFA Level II ExamCorporate IssuersEasy
An analyst is evaluating two companies, Company A and Company B, operating in the same industry. Company A has a debt-to-equity ratio of 0.8, while Company B has a debt-to-equity ratio of 1.5. Both companies have similar business risk. Based on this information and assuming a Modigliani-Miller (MM) framework with taxes, which of the following statements is most accurate regarding their cost of equity?
- ACompany A's cost of equity is higher than Company B's.
- BThe cost of equity cannot be compared without knowing the tax rate.
- CCompany B's cost of equity is higher than Company A's.
- DBoth companies have the same cost of equity due to the MM propositions.
Show answer & explanationAnswer & explanation
Correct answer: C. Company B's cost of equity is higher than Company A's.
According to Modigliani-Miller Proposition II with corporate taxes, the cost of equity increases with leverage. Since Company B has a higher debt-to-equity ratio (more leverage) than Company A, its cost of equity will be higher.
Why the other options are wrong
- A. This is incorrect; higher leverage generally leads to a higher cost of equity.
- B. While the tax rate affects the *magnitude* of the difference, the directional relationship (higher leverage means higher cost of equity) holds regardless.
- D. This would only be true under MM Proposition II without taxes, which is not the assumption here.
MM Prop II with Taxes
Modigliani-Miller Proposition II with corporate taxes states that the cost of equity increases linearly with the debt-to-equity ratio, adjusted for the tax shield.
- Re = R0 + (R0 - Rd)(1 - t)(D/E)
- Cost of equity increases with leverage.
- Tax shield benefits debt holders and increases firm value, but also increases equity risk.
Memory trick: Leverage Lifts Equity's Load, but also its cost.