Question 10, page 79 in the corporate finance book. I disagree that the asset risk (beta) does not change with a higher dept-to-equity ratio since: Basset = Bequity / ( 1 + (1-t)D/E) If the answer was true then Bequity must change in a proportionate way to a change in D/E, which I dont think is true. What do you think? Andreas
Hi Andreas As the proportion of debt increases in the D/E ratio then the cost of equity does increase (to compensate for the additional risk) therefore Bequity would increase. Check out proposition II in this Wikipedia link, about a third of the way down the page. http://en.wikipedia.org/wiki/Modigliani–Miller_theorem “A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt.” Cheers
Hi The+1Guy Thanks for your reply. Actually, my point refers to the asset risk not equity risk (here I agree). Regards Andreas
You’re losing the forest for the trees. How could Basset change according to how its financed? The asset doesn’t know how it’s financed. In that formula Bequity changes proportionate to the denominator as that’s how it’s derived.