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Required rate
of return (%)
}
K B = 11.0 - - - - - - - - - - - - - - - - - - - - - - - - - - - -
------------------------
r
= KB - R F
B
r=K -R
{ K A = 8.0 - - - - - - - - - -
-----------------
A A F R F = 6.0
0 σ1 σ2 Risk(σ)
(4%) (10%)
--------------------------
2 1
kA =10 - - - - - - - - - -
-------------------
2
R F2 = 8
RF = 6
1
Required rate
of return (%)
CML 2 = 6.0 + .7 σ
(pessimistic)
k
B2 =13
---------------------------- CML 1 = 6.0 + .5 σ
--------------------------
----------------------------
(optimistic)
k
B1 =11
k A2 =8.8 -------------
----------------
-------------
k
A1 =8.0
R
F =6
4% 10% Risk (σ )
Consider three firms in the same industry that are identical except for their financial policies.
FIRM A
Total debt $0
Net worth of equity $200
____ investors ____
Total assets $200 Total liabilities $200
(claims)
FIRM B
FIRM C
Economic Conditions
Indifference Good
Very poor poor Normal Very Good
Level
Rate of return on assets before interest
and taxes 2% 5% 6% 8% 11 % 14%
Earnings before interest and taxes (EBIT) $4 $10 $12 $16 $22 $28
aThe tax calculation assumes that losses are carried back and result in tax credits
15
B: Debt/assets =
50 percent
10
5
A: Debt/assets = 0 percent
3
0
5 6 10 15 20
Rate of return on assets
(before corporate income taxes)
-5
Retu rn on equit y
Leverage rat io
Af t er t ax co st
of capit al
Cost o f equit y
Cost o f debt
Leverage
rat io
Note: the more stable the industry is, the higher the optimal leverage ratio
(i.e., the greater the use of debt)
Marginal co st
of capit al
IRR
Complications:
1. Determination of optimal capital structure/marginal cost of capital curve is complex.
2. Effect of capital rationing. Firms may be unwilling to operate at the intersection:
• Uncertainties in projections may cause firm to ‘play it safe’
• Expectation of better investment opportunities in future years may cause firms to stop short of
intersection point.