Would capital structure have an impact on cost of equity?
Going by CAPM, there doesn't seem to be any determinants in the equiation that impact the cost of equity but just thinking intuitively, it seems that if a company takes on more debt, then it becomes a more "risky" investment for equity holders and they should demand a premium for this risk, thus taking the cost of equity higher when a company increased debt and possibly vice versa. Does this make sense?
Thanks!
learn capm kiddo. its in the equation.
Yes, taking on more debt does increase the required rate of return on equity as the risk profile of the company increases. This will also increase the weighted average cost of capital (WACC) as it is a weighted average between the costs equity and debt.
(On an interestng note for you beginners, taking on debt will often lower the WACC because the interest rates on bonds are usually less than the return demanded by the stock owners because the debt has priority claim over company assets. So at first the WACC is lowered by taking on some debt, even though the required return on equity increased. Beta, being part of the req rate of return on equity also increases.)
Eventually, increasing the leverage will increase WACC because the new issues of bonds will command a higher interest rate. Beta and the and the cost of equity will always increase as debt increase. There are formulas for all this but you haven't covered them in your curriculum yet. It's good that you're thinking ahead though.
The equation for finding unlevered Beta is:
B unlevered= (B levered)/(1+(1-T)*(D/E))
So as you can see, when the debt/equity ratio increases, the difference between unlevered and levered beta increases.
Hey expert, read your books again, cuz everything above is bullshit.
I would have to concur with tandaradei, particularly the second paragraph lol. Tax shield buddy.
what's wrong with the second paragraph? initially taking on debt lowers the WACC but once you take on too much debt the firm is perceived as risky and thus investors demand a a higher return. So when the marginal cost of borrowing (bankruptcy costs of debt) outweigh the marginal benefits of borrowing (tax shield), WACC will start going up, and firm value will start going down.
You're absolutely right, it is a tradeoff between tax shield and bankruptcy costs. WACC goes down because of the tax shield, not because of lower required rate of return on debt.
in practice, its all about what the market says your cost of equity will be.... clearly we have a serial finance major still in college asking theoretical questions here. will your professors seriously not answer these for you? you must go to some bottom tier school
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