Question

In a world where corporate taxation exists, MM Proposition II

a) implies that the required return on equity is a result of homemade leverage.

b) implies that the required return on equity is a linear function of the market's rate of interest.

c) implies that the required return on equity is inversely related to the firm's debt-to-equity ratio.

d) implies that the required return on equity is independent of the firm's capital structure.

e) implies that the required return on equity is directly affected by the firm's debt-to-equity ratio.

Answer 1

MM Proposition II with taxes states that the cost of equity is directly proportional to the debt to equity ratio of the firm. The formula for return on equity under MM Proposition II is given as:

Re = Ra + (D/E)*(1-tax rate)*(Ra-Rd)

Where

Re is return on levered equity

Ra is return on unlevered equity

D/E is the debt to equity ratio

Rd is cost of debt

a) incorrect. Homemade leverage is the use of loan by investors to change the effects of a unlevered firm to a levered firm. Required return on equity is not a result of homemade leverage.

b) incorrect. Market's rate of interest does not come into picture. As shown in the formula above, the required return on equity is directly affected by the firm's debt to equity ratio.

c) incorrect. There is a direct relationship.

d) incorrect. Firm's capital structure has an impact on the required return on equity. The required return on equity is directly affected by the firm's debt to equity ratio.

e) correct. As shown by the formula above, the MM proposition II states that the required return on equity is directly affected by the firm's debt to equity ratio.

Thus, the correct option is e.