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Unformatted text preview: r unfortunate event. 9. a. As the debt/equity ratio increases, both the cost of debt capital and the cost of
equity capital increase. The cost of debt capital increases because increasing the
debt/equity ratio increases the risk of default so that bondholders require a higher
rate of return to compensate for the increase in risk. The cost of equity capital
increases because increasing the debt/equity ratio increases the financial risk
borne by the stockholders; a higher rate of return is required to compensate for this
increase in risk. b. For higher levels of the debt/equity ratio, we have the cost of debt capital
increasing and approaching (but never being equal to, or greater than) the cost of
capital for the firm. Similarly, the cost of equity capital will also continue to rise; in
particular, it can not decrease beyond a certain point. 10. a. As leverage is increased, the cost of equity capital rises. This is the same as
saying that, as leverage is increased, the ratio of the income after interest (which is
the cash flow stockholders are e...
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This note was uploaded on 04/26/2013 for the course MATH 289Q taught by Professor Jamesbridgeman during the Fall '04 term at UConn.
- Fall '04