CMAEPR $(10$ points$)$ JKL$.$ Co$.$ has no debt, and its current cost of capital is $9\%,$ A bank is willing to kend to JKL at $6\%.$ Suppose that JKL borrows at this rate and converts to a debt$-$equity natio of $0\mathrm{.}5.$

a$)$ Will JKL$\text{'}$s new cost of equity increase, decrease, or remain the same?

Modigliani and Miller's Proposition II confirms that financial leverage will increase a firm's cost of equity.

b$)$ Ignoring taxes and other benefits and costs of debt, what return will JKL$\text{'}$s equity investors require at this new debt$-$equity ratio of $0\mathrm{.}5?$

When a company is all$-$equity financed, its cost of equity is the same as its WACC.

With leverage, JKL$\text{'}$s cost of equity will rise, according to MM II$,$ to $r_E,r_A,(r_A,r_D)\frac{D}{E}=9\%(9\%-6\%)(0\mathrm{.}5)=10\mathrm{.}5\%$

c$)$ Ignoring taxes and other benefits and costs of debt, what will JKL$\text{'}$s new WACC be$?$

WACC does not change if there are no taxes and other benefits and costs to debt, as pointed out by MM Proposition I. For a $.5$ debt$-$to$-$equity ratio, leverage $\frac{D}{DE}=.\frac{5}{\mathrm{.}51}=\frac{1}{3}.$ And for $Tc=0,$

WACC $,B(1,T_C)r_D,F_F,\frac{s}{3}(1,0)6\%,\frac{1}{3}10\mathrm{.}5\%,9\%$