M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC?

Question

Quizplus · Accepted Answer

According to Modigliani and Miller Proposition 2, the WACC is independent of the capital structure. Therefore, the WACC for Gangland Water Guns, Inc. is:

WACC = E/(D+E) * Re + D/(D+E) * Rd

where E is the market value of equity, D is the market value of debt, Re is the cost of equity, and Rd is the cost of debt.

The debt-to-equity ratio is given as 0.5, which means that D/E = 0.5.
Therefore, D/(D+E) = 0.5/(0.5+1) = 0.33
and E/(D+E) = 1 - D/(D+E) = 0.67

Using Re = 13% and Rd = 7%, we get:

WACC = 0.67 * 13% + 0.33 * 7% = 9.94%

The nearest option is C, 11%, but 9.94% is a more accurate answer.