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Biassumemmarecorrectthemarketvalueofthefirmisdetermine

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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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