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

(^610) © The McGraw−Hill
Companies, 2002
CHAPTER 17 Financial Leverage and Capital Structure Policy 583

FIGURE 17.5

Cost of

capital

(%)

RE = 10.22%

Debt-equity ratio

(D/E)

RU = 10%

WACC = 9.6%

RD  (1 – TC)

= 8%  (1 – .30)

= 5.6%

$1,000/6,300 = D/E

M&M Proposition I with taxes implies that a firm's WACC decreases

as the firm relies more heavily on debt financing:

WACC = )  RE   RD  (1 – TC)

M&M Proposition II with taxes implies that a firm's cost of equity,

RE, rises as the firm relies more heavily on debt financing:

RE = RU  (RU – RD)  (D/E)  (1 – TC)

WACC

RD  (1 – TC)

RE

RU

—E

( V)

—D

( )V

The Cost of Equity and the WACC: M&M Proposition II with Taxes

Because the firm is worth $670 total and the debt is worth $500, the equity is worth $170:

EVL
D

$670 
 500

$170

Based on M&M Proposition II with taxes, the cost of equity is:

RERU(RU
RD) (D/E) (1 
TC)

.20 (.20 
.10) ($500/170) (1 
.34)

39.4%

Finally, the WACC is:

WACC ($170/670) 39.4% (500/670) 10% (1 
.34)

14.92%

Notice that this is substantially lower than the cost of capital for the firm with no debt

(RU20%), so debt financing is highly advantageous.