Page 117 - AFM Integrated Workbook STUDENT S18-J19

The weighted average cost of capital (WACC)

2.4 Modigliani and Miller’s (M&M’s) Proposition 2

M&M's gearing theory was covered in Chapter 4: The financing decision.

As part of their theory, they derived a formula which can be used to derive a firm's
cost of equity:

i
i
k e = k e + (1–T)(k e – k d )(V d / V e)
(this formula is given on the formula sheet)

Where V e and V d are the market values of equity and debt.

k d is the (pre-tax) return required by the debt holders.

T is the tax rate

k e is the cost of equity in the geared firm

i
ke is the cost of equity in an equivalent ungeared firm

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