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[solution]: 20. Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of debt...


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20.        Business and Financial Risk   Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, R . Define b as the firm’s asset beta—that is, f                           A the systematic risk of the firm’s assets. Define bE to be the beta of the firm’s equity. Use the capital asset pricing model (CAPM) along with M&M Proposition II to show that bE 5 bA 3 (1 1 DyE), where DyE is the debt–equity ratio. Assume the tax rate is zero.

 


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