Response of the cost of equity to leverage: an alternative perspective

In this paper we examine the change in a corporation's cost of equity as the corporation increases leverage. Standard textbook treatments present the well-known Modigliani-Miller hypothesis that the cost of leverage increases linearly with increases in the debt-to-equity ratio in keeping with a...

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Bibliographic Details
Published in:Journal of business strategies 2015-09, Vol.32 (2), p.110
Main Authors: Pettengill, Glenn N, Lander, Diane M
Format: Article
Language:English
Subjects:
Analysis
Arbitrage
Bankruptcy
Capital costs
Capital structure
Cash flow
Corporate finance
Corporations
Cost of capital
Debt financing
Economic models
Equity
Finance
Investments
Leverage
Leverage (Finance)
Return on assets
Stockholders
Textbooks
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Summary:In this paper we examine the change in a corporation's cost of equity as the corporation increases leverage. Standard textbook treatments present the well-known 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.
ISSN:0887-2058
2162-6901