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Unformatted text preview: n framework for use in making capital structure decisions
should include the two key factors of return and risk. This section describes the
procedures for linking to market value the return and risk associated with alternative capital structures. Linkage
To determine the firm’s value under alternative capital structures, the firm must
find the level of return that must be earned to compensate owners for the risk
being incurred. Such a framework is consistent with the overall valuation framework developed in Chapters 6 and 7 and applied to capital budgeting decisions in
Chapters 9 and 10.
The required return associated with a given level of financial risk can be estimated in a number of ways. Theoretically, the preferred approach would be first
to estimate the beta associated with each alternative capital structure and then to
use the CAPM framework presented in Equation 5.8 to calculate the required
return, ks. A more operational approach involves linking the financial risk associated wit...
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