Modigliani and Miller (M&M), in a world of perfect capital markets, what will be the expected equity return (or cost of equity) for a firm that has a cost of capital of 10 percent, a cost of debt of 6 percent, debt valued at $1

Finance Dec 12, 2020

Modigliani and Miller (M&M), in a world of perfect capital markets, what will be the expected equity return (or cost of equity) for a firm that has a cost of capital of 10 percent, a cost of debt of 6 percent, debt valued at $1.2 million, and equity valued at $1.0 million?

Expert Solution

Computation of Expected Equity Return (Cost of Equity):

Value of Debt = $1.2 million

Value of Equity = $1.0 million

Value of Total Capital = $1.2 million + $1.0 million = $2.2 million

Weight of Debt = $1.20 million / $2.2 million = 54.55%

Weight of Equity = $1.0 million / $2.2 million = 45.45%

According to Modigliani and Miller? (M&M), in a world of perfect capital? markets, tax rate is zero.

So cost of equity is calculated below:

10% = (Cost of Equity * 45.45%) + (6%*54.55%)

10% - 3.27% = (Cost of Equity * 45.45%)

Cost of Equity = 6.73% / 45.45% = 14.80%

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