CFA Level II ExamCorporate IssuersEasy
A financial analyst is evaluating the impact of different financing choices on a company's cost of equity. The company currently has no debt. According to Modigliani-Miller Proposition II (M&M II) without taxes, which of the following statements is most accurate regarding the cost of equity as the company increases its leverage?
- AThe cost of equity will increase linearly as leverage increases.
- BThe cost of equity will increase at a decreasing rate as leverage increases.
- CThe cost of equity will remain constant regardless of the change in leverage.
- DThe cost of equity will decrease linearly as leverage increases.
Show answer & explanationAnswer & explanation
Correct answer: A. The cost of equity will increase linearly as leverage increases.
According to M&M Proposition II without taxes, the cost of equity increases linearly with leverage because the financial risk for equity holders rises as the company takes on more debt. This increase in risk demands a higher return from equity investors.
Why the other options are wrong
- B. M&M II without taxes describes a linear relationship, not one with a decreasing rate of increase.
- C. The cost of equity changes with leverage due to the changing financial risk borne by equity holders.
- D. M&M II without taxes states that the cost of equity increases, not decreases, with leverage.
M&M Proposition II (No Taxes)
States that the cost of equity for a leveraged firm is a linear function of the debt-to-equity ratio, reflecting the increased financial risk borne by equity holders.
- Assumes no taxes, no transaction costs, and perfect capital markets.
- Cost of equity increases with financial leverage.
- WACC remains constant regardless of leverage.
Memory trick: Leverage's rise makes equity's slice price.