Modigliani-Miller

[shah747]

I came across the following statement in Schweser under "MM Proposition 2 (No Taxes) :

r_e = r₀ + D/E(r₀-r_d)

“As leverage increases (i.e, the debt-to-equity ratio rises), the cost of equity increases, but WACC and the cost of debt are unchanged.”

I can understand the reasoning behind the cost of equity increasing as the firm becomes riskier, but wouldn’t the increase in leverage also affect the cost of further borrowing (Marginal cost of debt)? Why does the cost of debt remain unchanged?

[S2000magician]

At this stage MM is assuming no distress costs.

Later on you’ll see that the cost of debt increases as leverage increases.

[shah747]

Okay, so it is basically an assumption. Thanks!

[S2000magician]

My pleasure.