In M&M Proposition II the cost of equity changes with changes in the amount of debt financing.Which of the following is the correct formula for Proposition II? A)K_e = K_u + (K_u - K_d)/ ( $\frac { D } { E }$ ) B)K_e = K_u + (K_u - K_d)( $\frac { D } { E }$ ) C)K_e = K_u + (K_u + K_d)( $\frac { D } { E }$ ) D)K_e = K_u + (K_u + K_d)/ ( $\frac { D } { E }$ )

Question

Quizplus · Accepted Answer

The correct formula for M&M Proposition II, which describes how the cost of equity increases with leverage, is: $r_E = r_0 + (r_0 - r_D) \left( \frac{D}{E} \right)$, where $r_E$ is the cost of equity, $r_0$ is the cost of capital for an all-equity firm, and $r_D$ is the cost of debt. Choice B is a representation of this formula, indicating that the cost of equity increases with the debt-to-equity ratio ($\frac{D}{E}$).

In M&M Proposition II the Cost of Equity Changes with Changes