Response of The Cost of Equity To Leverage: An Alternative Perspective
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Keywords

Cost of Equity
Leverage
Modigliani-Miller Framework

How to Cite

Pettengill, G., & Lander, D. (2015). Response of The Cost of Equity To Leverage: An Alternative Perspective. Journal of Business Strategies, 32(2), 110–138. https://doi.org/10.54155/jbs.32.2.110-138

Abstract

In this paper we examine the change in a corporation’s cost of equity as
the corporation increases leverage. Standard textbook treatments present the wellknown
Modigliani-Miller hypothesis that the cost of leverage increases linearly with
increases in the debt-to-equity ratio in keeping with a constant cost of capital for the
firm. Less frequently, textbooks present the Modigliani-Miller argument that, if the
cost of debt rises with high levels of leverage, the cost of equity will increase at a
decreasing rate or even decline in order to keep the overall cost of capital constant.
Standard textbook presentations continue with additional discussions concerning
tax effects and bankruptcy costs but without mention of the cost of equity. These
presentations leave the impression that the cost of equity remains as presented
in the Modigliani-Miller framework. In this paper we present theoretical and
empirical arguments in support of our claim that the cost of equity increases slowly
with moderate increases in debt but increases dramatically as leverage increases
sufficiently to cause equity investors to fear bankruptcy.

https://doi.org/10.54155/jbs.32.2.110-138
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