Finance · level 2
MM Proposition II
In a perfect market the WACC is pinned to the asset risk. Add debt and the cost of equity climbs just enough to offset the cheaper debt.
Worked example: Unlevered cost of capital 10%, cost of debt 6%, debt-to-equity 1.5. Ignoring taxes, what is the levered cost of equity?
Step by step
- 1
MM II
r_E = r_U + (D/E)(r_U − r_D)
- 2
Plug in
10% + 1.5 × (10% − 6%) = 16%
- 3
Check the WACC
40% × 16% + 60% × 6% = 10% = r_U
- 4
Meaning
Leverage does not create value by swapping cheap debt for dear equity — equity simply gets riskier by exactly the amount that keeps the WACC flat.
Unlevered cost of capital 10%, cost of debt 6%, debt-to-equity 1.5. Ignoring taxes, what is the levered cost of equity? = 16
The theory behind it
Intuition
Finance is time and risk applied to cash: move every cash flow to the same date at a rate that reflects its risk, then compare.
Common pitfalls
- ×Discounting a nominal flow at a real rate (or vice versa).
- ×Mixing enterprise-value and equity-value numbers in the same ratio.
In the interview
Valuation, WACC, LBO and accretion rounds — where a wrong bridge is a wrong answer.