MM-II Without Taxes - Higher Debt Cost Means Lower Cost of Equity?

CFA Level II Corporate Finance
#1

I’m struggling to understand what seems like a perverse outcome of the MM proposition II without taxes.

MM-II without taxes states that as the ratio of debt increases, the cost of equity will increase proportionally to offset the lower cost of debt and maintain the same WACC as the unlevered company. So far this is logical.

What is confusing is the following example:

Suppose we have two companies, A and B, both with a required rate of return (WACC) of 10.0%, and both financed equally by debt and equity. Company A has a cost of debt of 4.0% and company B has a cost of debt of 8.0%. Based on the equation:

re = r0 + (r0 - rd) x (D / E) [equation (4) in the text page 97].

We get a cost of equity for company A of 16.0% and a cost of equity for company B of 12.0%. Surely this can’t be correct? All else being equal, a company with a higher cost of debt funding should be more risky for the equity holders than the same company with a lower cost of debt. Is there something I am missing? Appreciate any thoughts.

#2

The MM-II without tax has no factor for financial distress. Also, that equation you listed, R_0 is full equity and no debt.

Static Tradeoff: If you factor in the costs of financial distress, there is an optimal structure such that WACC is minimized and VALUE is maximized. This occurs when the marginal benefit of debt = marginal cost of financial distress. So 100% debt is not optimal, cause financial distress costs increase as your Debt level increases - and eventually, the benefit of the tax shield will be offset by the fin distress costs. So there is a “tradeoff”

Read: https://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91267415