Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

© The McGraw−Hill^603

Companies, 2002

The Cost of Equity and Financial Leverage:

M&M Proposition II

Although changing the capital structure of the firm does not change the firm’s total

value, it does cause important changes in the firm’s debt and equity. We now examine

what happens to a firm financed with debt and equity when the debt-equity ratio is

changed. To simplify our analysis, we will continue to ignore taxes.

Based on our discussion in Chapter 15, if we ignore taxes, the weighted average cost

of capital, WACC, is:

WACC (E/V) RE(D/V) RD

where VED. We also saw that one way of interpreting the WACC is as the re-

quired return on the firm’s overall assets. To remind us of this, we will use the symbol

RAto stand for the WACC and write:

RA(E/V) RE (D/V) RD

If we rearrange this to solve for the cost of equity capital, we see that:

RERA(RA
RD) (D/E) [17.1]

This is the famous M&M Proposition II, which tells us that the cost of equity depends

on three things: the required rate of return on the firm’s assets, RA, the firm’s cost of

debt, RD, and the firm’s debt-equity ratio, D/E.

Figure 17.3 summarizes our discussion thus far by plotting the cost of equity capital,

RE,against the debt-equity ratio. As shown, M&M Proposition II indicates that the cost

of equity, RE,is given by a straight line with a slope of (RA
RD). The y-intercept cor-

responds to a firm with a debt-equity ratio of zero, so RAREin that case. Figure 17.3

shows that, as the firm raises its debt-equity ratio, the increase in leverage raises the risk

of the equity and therefore the required return or cost of equity (RE).

576 PART SIX Cost of Capital and Long-Term Financial Policy

M&M Proposition II
The proposition that a
firm’s cost of equity
capital is a positive linear
function of the firm’s
capital structure.

FIGURE 17.3

The Cost of Equity and

the WACC: M&M

Propositions I and II

with No Taxes

Cost of capital

(%)

WACC  RA

Debt-equity ratio

RE

RE R (^) A (RA
R (^) D)  (D/E) by M&M Proposition II
RA WACC   RE  RD
RD
where V D  E
E
( )V
D
( )V
(D/E)