Moonlight Ltd is an unlevered firm with a cost of equity of 7% and a tax rate of 30%.
Required:
i) Using Modigliani and Miller’s theory with corporate taxes (but no bankruptcy costs), calculate
the cost of equity of a levered firm in the same tax bracket that pays interest at 3% and has a debt to equity ratio of 40%.
ii) Explain (with calculations) what would happen to the cost of equity of the levered firm if the debt to equity ratio increased to 70%