Why WACC is the same no matter what the Debt-Equity Ratio in M&M Proposition 2 theory?
The basic M& M theory excludes taxes with the proposition 2 considering the effect of income taxes , but a revised focus incorporating tax effects generally considers overallcost of capital unchanged regarless of capital structure becasue interest rates on debt will ten to rise for an entity as the proportion of total capital comprised of debt rises, implicitly holding equity capital costs relatively constant. I am not sure an entity’s equity capital costs are unrelated to its leverage, but suspect equity capital demands a preminum for a more highly leveraged structure, raising total cost of capital as leverage increases. WACC only need to also consider risk associated with the capital structure, as the debt component of capital structure is subject to interest rate and liquidity/credit availablilty risks. My sense as a practioner and an investor is that riskier capigtal structures should be, and genereally are, more costly.
