9. Proposition 2 equation for the levered cost of Equity For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT – Interest Expense From Proposition 1 (1) (2) Substitute (2) into (1) This is the Proposition 2 equation
10. MM Proposition 2: No taxes Cost of Capital (%) Debt/Value Ratio (%) r s WACC r d r sU
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13. MM Proposition 2 with Taxes r sL increases with leverage at a slower rate when corporate taxes are considered. The WACC continues to decline as new debt is added. Risk premium now includes (1-T)
14. Cost of Capital (%) Debt/Value Ratio (%) MM Proposition II: With taxes r s WACC r d (1 - T) r sU
15. Value of Firm, V (%) Debt V L V U MM relationship between value and debt with taxes TD V U