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Can I use M&M formula to calculate the revised cost of equity (ke) for part B?
As per my understanding, M&M formula can be used when gearing change. In this question, Rosa is considering a scheme to repay existing debt of $800m and issue new debt of $2,400m which will result in an increased gearing of Jupiter. Ke increases as gearing increases which match the M&M model (with tax).
Please correct me if I am wrong. Thank you.
You are correct.
M&M does rely on certain assumptions which are not necessary valid on real life.
However in this question we have no choice but to either use the CAPM formulae as the examiners answer does (and these formula are derived from the M&M formulae) of alternatively use the M&M formula themselves.
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