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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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- Fall '04