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The Cost of Capital and Leveraged  s R i = R f +  i, l *[R m - R f ]

What is Financial Leverage? Financial leverage refers to the firm’s use of fixed-claim securities to finance its assets. These securities typically include debt and/or preferred stock. Using fixed claim securities that have prior claims to the firm’s assets makes the residual claims of the common stockholders more uncertain. Therefore, common stockholders require higher rates of return when the firm uses debt or preferred stock than when it does not.

An Illustration of the Effects of Financial Leverage? Suppose a new firm is investing in assets that cost \$10,000,000. One alternative for financing these assets is to use all equity. The book-value balance sheet for the firm would be: Assets = \$ 10,000,000 Debt = \$ 0 Equity = \$ 10,000,000 Total = \$ 10,000,000 A second alternative for the firm is to use 50% debt and 50% equity. In this case, the book-value balance sheet for the firm would be: Assets = \$ 10,000,000 Debt = \$ 5,000,000 Equity = \$ 5,000,000 Total = \$ 10,000,000

Debt and Equity Values Across States of Nature with Safe Investment with and without Debt Financing

Equity Values with Safe Investment and No Debt

Debt and Equity Values with Safe Investment and Debt Financing

The Effect of Debt on  when Debt is Risk Free The portfolio of securities issued by the firm consists of debt and equity. The portfolio  is a weighted average of the  s of the securities in the portfolio. Therefore, What is the  for the firm’s equity? What is the  for this firm’s equity if the  for the assets is 1.0?

Debt and Equity Values Across States of Nature with Risky Investment with and without Debt

Equity Value Across States of Nature with Risky Investment and Without Debt Financing

Debt and Equity Values Across States of Nature with Risky Investment and Debt Financing

The Effect of Debt on  when Debt is Risky As before, the equity  can be expressed as What is the  for this firm’s equity if the  for the assets is 1.0 and the  for the debt is.30?

The Effect of Debt on The Cost of Equity When Debt is Risk Free According to the Security Market Line, the cost of equity is given by The  s we observe are most frequently leveraged. If we separate the effects of asset or business risk from the effects of financial leverage, we can determine how much larger the risk premium is because of our financing choice.

The Effect of Debt on The Cost of Equity When Debt is Risk Free

Numerical Example: Suppose a firm currently has \$500 million in debt and \$1,000 million in equity. One-year Treasury bills are yielding 6%, the expected market risk premium is 8%, and the leveraged  is 1.5. –What is the cost of equity? –How large is the business risk premium? –How large is the financial risk premium? –Suppose the firm is considering a leveraged recapitalization in which it will issue an additional \$500 million to retire \$500 million in equity. What will the new financial risk premium be?

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