M&M Proposition II, without taxes, puts forth that. Multiple Choice
Multiple Choice
the capital structure of a company has no effect on that company’s value.
the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
M&M Proposition II, without taxes, puts forth that. Multiple Choice
a company’s cost of equity is a linear function with a slope equal to (RARD).
the cost of equity is equivalent to the required rate of return on assets.
the size of the pie does not depend on how the pie is sliced.
The Correct Answer and Explanation is :
The correct answer is:
a company’s cost of equity is a linear function with a slope equal to (RARD).
Explanation:
M&M Proposition II without taxes argues that a company’s cost of equity (Ke) increases linearly as the company increases its leverage (use of debt financing). According to this theory, the cost of equity is a linear function of the company’s debt-to-equity ratio (D/E). The proposition can be mathematically expressed as follows:
[ Ke = Ra + (Ra – Rd) \times \left(\frac{D}{E}\right) ]
Where:
- ( Ke ) is the cost of equity.
- ( Ra ) is the required rate of return on assets (also interpreted as the company’s overall cost of capital when unlevered).
- ( Rd ) is the cost of debt.
- ( D/E ) is the debt-to-equity ratio.
The key insight of M&M Proposition II is that as a firm increases its use of debt financing, the risk of equity increases. This is because debt holders have a fixed claim on the firm’s cash flows (interest payments), and in scenarios of financial distress or liquidation, they are paid before equity holders. As a result, equity holders demand a higher return to compensate for this increased risk.
The term ( (Ra – Rd) ) represents the difference in the cost between return on assets and the cost of debt, indicating the additional risk premium that equity holders require over the return on assets as the company uses more debt financing. This premium is then scaled by the proportion of debt in the company’s capital structure (( \frac{D}{E} )), indicating that the risk to equity holders increases with higher levels of debt.
This proposition shows that while the overall value of the firm remains unchanged (as per M&M Proposition I without taxes), the required returns by equity holders adjust upward as more debt is employed. This is a direct consequence of the increased financial risk borne by equity holders, which is not offset by any tax shield benefits in the no-tax scenario that M&M Proposition II considers.