The higher beta on equity is exactly being offset by

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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 further borrowing. 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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