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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· §
¨ED ¸ ¨EE ¸
© 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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