Prof. Ian Giddy, New York University What happens to a company's required return on equity when it increases leverage, i.e. the proportion of debt in its total financing? Answer -- the required return increases. But how, and how much? This note tries to answer that question. The Required Return on Equity How does one look for the required return on equity, to use to discount the cash flows in a project? The pure equity required rate of return, according to the Capital Asset Pricing Model, depends on how risky the firm or project is relative to the market (its Beta)
= RISKFREE RATE + RISK PREMIUM (which depends on the Beta and the market risk premium)
The Effect of Leverage
= UNLEVERED ROE + RISK PREMIUM DUE TO LEVERAGE
Introduce Taxes
we can derive the tax version of the Leveraged ROE equation:
Find the Project's or Company's NPV Change the assumptions as you see fit, either because they are wrong, or to perform sensitivity analysis. Related Material |

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