Unformatted text preview: n equity will be increasing in the debt-equity ratio. (45) EE E A E A E D D
E Please click the advert Again, notice MM's proposition I translates into no effect on the beta on assets of increasing the financial
leverage. The higher beta on equity is exactly being offset by the substitution effect as we swap equity
with debt and debt has lower beta than equity. Download free ebooks at bookboon.com
61 Corporate Finance Corporate ﬁnancing and valuation 8.5 How capital structure affects company cost of capital
The impact of the MM-theory on company cost of capital can be illustrated graphically. Figure 9 assumes
that debt is essentially risk free at low levels of debt, whereas it becomes risky as the financial leverage
increases. The expected return on debt is therefore horizontal until the debt is no longer risk free and then
increases linearly with the debt-equity ratio. MM's proposition II predicts that when this occur the rate of
increase in, rE, will slow down. Intuitively, as the firm has more debt, the less sensitive shareholders are to
Figure 9, Cost of capital: Miller and Modigliani Proposition I and II
Rates of return Expected return on equity = rE Expect...
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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.
- Spring '12