M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the firm is financed with equity?

Question

Quizplus · Accepted Answer

According to M&M Proposition 2, the weighted average cost of capital (WACC) is equal to the cost of equity multiplied by the percentage of equity financing, plus the after-tax cost of debt multiplied by the percentage of debt financing. Mathematically, it can be written as:
WACC = E/V * Re + D/V * Rd * (1 - Tc)
where
E/V = percentage of equity financing
D/V = percentage of debt financing
Re = cost of equity
Rd = pretax cost of debt
Tc = marginal corporate tax rate

In this case, we have:
WACC = 8.5%
Re = 12%
Rd = 5%
Tc = 35%

Substituting these values and solving for E/V, we get:
8.5% = E/V * 12% + (1 - E/V) * 5% * (1 - 35%)
8.5% = 0.12E/V + 0.0325 - 0.0325E/V
0.0325E/V = 0.085 - 0.0325
E/V = 0.6

Therefore, 60% of the firm is financed with equity. The answer is B.

M&M Proposition 2: a Firm Has a WACC of 8