Question

3 (a) Sketch a graph illustrating the relationships between firm leverage and the required returns on equity and debt, and the weighted average cost of capital, according to the Modigliani-Miller no-taxes model. Provide an intuitive explanation of each of the relationships you have illustrated graphically. (190 words).

Answer 1

The graph for MM model wiithout taxes depicting the variance of cost of cost of debt, equity and WACC with leverage is as given below

The Cost of Debt remains initially the same for low increase in leverage but later increases as debt becomes costly due to already high amount of debt. The cost of equity increases due to increasing risk of leverage to shareholders. The levered cost of equity is given by

Levered Cost of equity =unlevered cost of equity + (unlevered cost of equity - cost of debt) * D/E

where D and E are the market values of Debt and equity

Now, because of these risks, the WACC cost of capital given by

WACC = D/(D+E) * cost of debt + E/(D+E) * levered cost of equity

= unlevered cost of capital

and therefore remains constant with changing leverage. Thus, the Cost of capital is not influenced or changed with changing leverage or D/E ratio