According to Modigliani and Miller (M&M), in a world of perfect capital markets, except that interest on debt is tax deductible, what will be the expected equity return (or cost of equity) for a firm that has a cost of capital of 14 percent, a cost
of debt of 8 percent, a tax rate of 30%, debt valued at $3.0 million, and equity valued at $4.0 million? What would happen to the cost of equity as the amount of debt increased? What would happen to the cost of debt if the amount of debt was increased?
Ke = Ku + (Ku - Kd) (1 - t) ( )
= 14% + (14% - 8%) * (1-.30 ) * (3/4 ) = 17.15%
The cost of equity would increase but the cost of debt would remain the same.
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