Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

Question

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Under the original Modigliani and Miller Capital Structure Theorem with no taxes, the cost of equity increases as a company increases its debt level. This is because equity becomes riskier to compensate for the increased risk of debt in the company's capital structure. In this scenario, borrowing at 10% to buy back half of its stock would increase the financial risk to the remaining equity holders, causing the cost of equity to rise.

Chelsea Corporation's Cost of Equity Is 16% and It Is