Finally notice that even though the expected return

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Unformatted text preview: re amplified: If operating income falls the percentage decline in the return is larger for levered equity since the interest payment is a fixed cost the firm has to pay independent of the operating income. Finally, notice that even though the expected return on equity is increasing with the financial leverage, the expected return on assets remains constant in a perfect capital market. Intuitively, this occurs because when the debt-equity ratio increases the relatively expensive equity is being swapped with the cheaper debt. Mathematically, the two effects (increasing expected return on equity and the substitution of equity with debt) exactly offset each other. Download free ebooks at bookboon.com 60 Corporate Finance Corporate financing and valuation 8.4 How capital structure affects the beta measure of risk Beta on assets is just a weighted-average of the debt and equity beta: (44) EA D· § E· § ¨ED ˜ ¸  ¨EE ˜ ¸ V¹ © V¹ © Similarly, MM's proposition II can be expressed in terms of beta, since increasing the debt-equity ratio will increase the financial risk, beta o...
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