COMMERCE 3FA3 Lecture Notes - Lecture 7: Capital Structure, Dissociation Constant, Risk Premium
17 Dec 2014
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Section 2: capital structure: mm proposition ii (no taxes) (the effect of capital structure on ke) While changing the firm"s capital structure will not affect the value of the firm, it will affect the cost of equity capital (ke). Multiply by b + s, (b+s)k = ske + bkd. Divide by s, and move ke to the lhs, In words, the cost of equity capital is a function of the firm"s debt-equity ratio. Because v doesn"t change with b/s, k won"t change either. (i. e. k = ebit/v). If, as mm assume, the debt is risk free, kd won"t change with b/s either. (iii) Further, because k includes a risk premium, k > kd. In light of (i), (ii) and (iii), we can strengthen our previous interpretation of mm ii and say that ke is an increasing linear function of b/s. When b/s = 0, ke = k (called p).
