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Unformatted text preview: e debt­holders are taking on more of the risk of the firm; the rate for common stock increases because of increasing financial leverage. See Figure 17.2 and the accompanying discussion. 5. a. Under Proposition I, the firm’s cost of capital (rA) is not affected by the choice of capital structure. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt­equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller proportion of the firm is financed by equity. The overall effect is to leave the firm’s cost of capital unchanged. b. Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average return to stockholders. 6. a. If the opportunity were the firm’s only asset, this would be a good deal. Stockholders would put up no money and, therefore, would have nothing to lose. However, rat...
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