ABC Ltd is an unlevered firm with a cost of equity of 6% and a tax rate of 40%.

Required:

i) Using Modigliani and Millers theory with corporate taxes (but no bankruptcy costs), calculate

the cost of equity of a levered firm in the same tax bracket that pays interest at 2% and has a debt to equity ratio of 20%.

ii) Advise ABC Ltd (with calculations) what would happen to the cost of equity of the levered firm if the debt to equity ratio increased to 50%.