In the context of Modigliani-Miller Proposition II, what does the cost of equity of a levered firm depend on?

The cost of equity for a levered firm, according to Modigliani-Miller Proposition II, is influenced significantly by the firm's capital structure, specifically its debt-to-equity ratio, as well as the costs associated with debt and unlevered equity.

This proposition indicates that as a firm increases its leverage by borrowing, the risk to equity holders also increases. This heightened risk leads equity investors to demand a higher return, reflecting the expected increase in financial risk. The formula derived from this proposition illustrates that the cost of equity is a function of the risk-free rate, the firm's beta, which accounts for the systematic risk of the firm, and additional risk premia associated with leverage. Essentially, the cost of equity rises linearly with the firm’s debt-to-equity ratio due to this increased risk.

In the context of the choices, this understanding confirms that the correct answer accurately highlights the specific factors—debt-to-equity ratio, costs of debt, and costs of unlevered equity—that determine the cost of equity for a levered firm. Other options, such as operational efficiency, market conditions, or overall cash flow, do not specifically address the relationship between leverage and the cost of equity as outlined in the Modigliani-Miller framework