As leverage increases the risk of debt debt holders

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Unformatted text preview: ed return on assets = rA Expected return on debt = rD Risk free debt Risky debt Debt Equity D E The expected return on equity, rE, increases linearly with the debt-equity ratio until the debt no longer is risk free. As leverage increases the risk of debt, debt holders demand a higher return on debt, this causes the rate of increase in rE to slow down. 8.6 Capital structure theory when markets are imperfect MM-theory conjectures that in a perfect capital market debt policy is irrelevant. In a perfect capital market no market imperfections exists. However, in the real world corporations are taxed, firms can go bankrupt and managers might be self-interested. The question then becomes what happens to the optimal debt policy when the market imperfections are taken into account. Alternative capital structure theories therefore address the impact of imperfections such as taxes, cost of bankruptcy and financial distress, transaction costs, asymmetric information and agency problems. Download free ebooks at 62 Corporate Financ...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.

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