James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.According to M&M, the cost of equity for Whispering Pines Resort will be:
A)greater than the cost of equity for James Bay Water Park.
B)the same as the cost of equity for James Bay Water Park.
C)less than the cost of equity for James Bay Water Park.
D)insufficient information is provided to answer the question.

Question

Quizplus · Accepted Answer

According to the Modigliani-Miller (M&M) theorem, the cost of equity is not affected by changes in the debt/equity ratio in the absence of taxes and financial distress. However, the cost of capital (WACC) will increase as the debt/equity ratio increases due to the increased cost of debt. Therefore, since Whispering Pines Resort has a higher debt/equity ratio, its WACC will be higher than that of James Bay Water Park, which means its cost of equity will also be higher. Thus, the correct answer is A, greater than the cost of equity for James Bay Water Park.

James Bay Water Park Operates in a World with Zero