Use the information for Silicon Solutions found in Figure 11.1 and assume perfect capital markets (PCM) to determine the average cost of capital for the unlevered firm

Then determine the return on shares, the return on debt, and the average cost of capital for the levered firm. What do you think will happen to the return on equity, return on debt, and the average cost of capital for the levered firm if the ratio of debt to equity is increased?

Silicon Solutions pays all of its operating income to shareholders as a dividend, which represents the return to the shareholders. Estimates for the firm's operating income next year, and in all subsequent years, is anticipated to be $1.0 million. Note that this is NOT a guaranteed amount, but simply the best guess of what the operating income will be. Because the firm does not expect the operating income to grow, and because all operating income is paid in dividends, the return to all shareholders will be the dividend yield they receive: $1.0 million relative to the $10 million market value of equity.

Use the formula for M&M Proposition II to solve this problem.
Ke = Ku + (Ku - Kd) ( )
For the unlevered firm there is no debt and thus the return on equity and the average cost of capital are identical. In this case, the return is $1/ $10 = 10%

When the firm substitutes debt for equity the cost of debt is calculated as (Interest payments/Value of debt) = $150,000/$2,500,000 = 0.06 = 6%. M&M postulate that under conditions of perfect capital markets, the average cost of capital does not change as the weights of debt and equity change. Thus, the average cost of capital remains as 10%. With a D/E ratio of .25/.75, Proposition II demonstrates that the cost of equity increases to .10 + (.10 - .06 )* (.25/.75 ) = 11.33%.

If the firm continues to substitute debt for equity, Proposition II demonstrates that the average cost of capital will not change, the return on equity will increase in a linear fashion, and the cost of debt under the assumptions of PCM will not change.