According to Modigliani and Miller (M&M), in a world of perfect capita

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?

ANSWER

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.