Can someone explain something:
Why does the cost of equity go up, as you use more debt?
I thought I understood this, but now I'm confused, so anyone who can help me out, it would be appreciated.
Thanks
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Qualitatively, as you increase debt the finacial risk of the company increases resulting in an overall riskier business. Investors will demand more return due to additional risk.
Quantitatively, increasing the D/E results in a higher levered beta BL=BU(1+(D/E)1-T)which will result in a higher CAPM equity rate of return.
This is Modigliani-Miller theory related that states that the cost of equity rises with leverage, because the risk to equity rises. Therefore, more debt (leverage) increases causing more risk causing the cost of equity to rise.
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