Debt is risk-free-cost of debt equals the risk-free rate

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Suppose a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate,formula32.mml . Define formula33.mml as the firm's asset beta—that is, the systematic risk of the firm's assets. Define formula34.mml to be the beta of the firm's equity. Assuming the tax rate is zero, it can be shown from the capital asset pricing model, (CAPM), along with MM Proposition II that formula35.mml , where B/S is the debt−equity ratio. Suppose a firm's business operations are such that they mirror movements in the economy as a whole very closely; that is, the firm's asset beta is 1.0. By using the above result find the equity beta for this firm for debt−equity ratios of 1, 2, 4, and 16. Debt-equity ratio Equity beta 1 2 4 16

Reference no: EM131063062

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