The equation for Ke in a levered structure is given as Keu (unlevered) + (Keu - Kd) (1-t) (D/E)
So, if we assume that there are no taxes and debt is equal to equity, then the lower the cost of debt, the higher the levered cost of equity? That doesn’t make sense to me. Any ideas?
That MM Proposition II (no tax) equation is to show that as the amount of debts increase, cost of levered equity increase so WACC is unchanged. Why would you care about this:
if we assume that there are no taxes and debt is equal to equity, then the lower the cost of debt, the higher the levered cost of equity
The conclusion is correct: the lower the cost of debt, the higher the levered cost of equity.
First, the cost of equity must be higher than the cost of debt, that’s pretty obvious. Now, as already mentioned above, look at the 2nd MM Proposition - the cost of equity is a linear function of the company’s D/E ratio. In other words, the higher the D/E the higher the cost of equity as equityholders will require higher return when they believe the risk is higher. Higher D/E is, despite all benefits, typically associated with higher risk.
It may be a wild assumption, so please someone correct me if I’m wrong, but a lower cost of debt may trigger an increased use of debt, and as a result increase in the D/E ratio (as it’s more attractive and WACC is the overall priority). This might, indirectly, explain why the cheaper the debt the pricier the equity.
That doesn’t make sense.
Keeping the Kd low even with a high D/E ratio gives you a high levered Ke.
The CAPM explains it better. MM equation does not in my view.
it just tells u - you have higher debt - you need a higher cost of equity - to meet the needs of your debt holders first - since they have priority and then to be able to meet the needs of your shareholders (equity partners).
the leverage from debt also magnifies the returns - if returns earned are higher - you have higher magnification. but if you experience losses - those become magnified as well.
This is something that the CAPM model does not really do - this explanation - so …