MM Proposition II, Leverage & the Cost of Equity

Calculates how leverage raises the cost of equity under Modigliani-Miller Proposition II without taxes, while the blended WACC stays at the unlevered return. Inputs are the unlevered return, the cost of debt, and the debt-to-equity ratio.

By Devon Coombs, CPA, MBA · Teaching Professor of Finance, Santa Clara University · Reviewed August 2026

From the author: Devon Coombs, CPA, MBA teaches finance at Santa Clara University and works with corporate teams on practical AI.

AI training for finance teams · Consulting · The 10 Laws of Finance

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MM Proposition II, Leverage & the Cost of Equity

Unlevered return (Rₐ)

Cost of debt (R_d)

Debt-to-equity ratio (D/E)

Cost of equity (R_e)

18.0%

Rₐ + (Rₐ − R_d) × D/E

WACC

12.0%

unchanged by leverage

Leverage premium

6.0%

(Rₐ − R_d) × D/E

Cheaper debt is exactly offset by a costlier, riskier equity, so in a frictionless world the WACC stays put at Rₐ. Leverage rearranges risk between claimholders; it does not, by itself, create value.

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Built by Devon Coombs, CPA, MBA, Teaching Professor of Finance at Santa Clara University.