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Unformatted text preview: eL , and a larger WACC. So the MM model will underestimate the value of the levered firm and its cost of equity and WACC. 17-5 If equity is viewed as an option on the total value of the firm with a strike price equal to the face value of debt then the equity value should be affected by risk in the same way that an option is affected by risk. An option is worth more if the underlying asset is more risky, so a manager wanting to maximize the option value of the firm might want to switch investment decisions to make the firm more risky. Of course bondholders will not like this, since the increase in equity value comes at their expense. They will write covenants in to the bonds specifying how the proceeds can be used, and if management still manages to engage in this bait and switch tactic, the firm will find it difficult to raise capital through bond issues in the future....
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- Spring '08