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sir, cant understand what the formula for M & M Proposition 2 basically means where it involves cost of equity og geared and ungeared firms,
what is it basically all about and is it related to M & M gearing theories?
I don’t know whether or not you have yet watched my lectures on CAPM (or how much you remember about it from Paper F9), but M&M2 is really a combination of MM gearing theories and CAPM.
The more gearing there is in a company then the more risky the shares become (and therefore the higher the equity beta) and therefore the shareholders required return (and hence the cost of equity) is higher in a geared company than if there was no gearing.
Just as the capital asset formula can be used to calculate how the equity beta will increase with higher gearing, so to the MM formula can be used to show how the cost of equity will increase with higher gearing (and in fact, both formulae end up giving the same result).
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