Required Rate of Return on Equity Examine a variety of different debt to equity ratios and the resulting required rate of return on equity. B/S k e 0.00 15.00% 15% 025 10% 16.25% 15% 0.50 10% 17.50% 15% 00 10% 20.00% 15% 2.00 10% 25.00% 15% 17-11 Calculated in slides 9 and 10
17-11 B / S ki ke ko 0.00 --- 15.00% 15% 0.25 10% 16.25% 15% 0.50 10% 17.50% 15% 1.00 10% 20.00% 15% 2.00 10% 25.00% 15% Required Rate of Return on Equity Examine a variety of different debt-to-equity ratios and the resulting required rate of return on equity. Calculated in slides 9 and 10
Required Rate of Return on Equity Capital costs and the Nol approach in a graphical representation. 25 =16.25%and 20[17.5%respectively ke(Required return on equity) .15 Ko(Capitalization rate) 10 Ki(Yield on debt) 8 05 0 0.2550751.01.251.501752.0 17-12 Financial Leverage(B/s)
17-12 Required Rate of Return on Equity Capital costs and the NOI approach in a graphical representation. 0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0 Financial Leverage (B / S) .25 .20 .15 .10 .05 0 Capital Costs (%) ke = 16.25% and 17.5% respectively ki (Yield on debt) ko (Capitalization rate) ke (Required return on equity)
Summary of NOl Approach Critical assumption is ko remains constant. An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity As long as ki is constant, ke is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure 17-13
17-13 Summary of NOI Approach Critical assumption is ko remains constant. An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity. As long as ki is constant, ke is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure