Diverse Contractor'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 happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem?
A)It would remain at 16%.
B)t would rise to 22%.
C)It would fall to 11%.
D)It would fall to 13%.

Question

Quizplus · Accepted Answer

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 higher risk of default. In this scenario, borrowing at 10% to buy back half of its stock introduces debt into the company's previously all-equity structure, thereby increasing the cost of equity beyond the original 16%.

Diverse Contractor's Cost of Equity Is 16% and It Is