The Effects of Debt Equity Policy on Shareholder Return Requirements and Beta (2024)

Abstract

This note outlines the link between shareholder-return requirements and a firm's use of debt. It explores the theoretical arguments concerning how the cost of equity changes with the use of debt and discusses the limitations of each view. It also provides conceptual and practical guidance on the use of "levered" and "unlevered" betas.

Excerpt

UVA-F-1168

THE EFFECTS OF DEBT EQUITY POLICY ON SHAREHOLDER

RETURN REQUIREMENTS AND BETA

This note outlines the link between shareholder return requirements and a firm's use of debt. We review specific theoretical models used to estimate how shareholders' risk premium will change as the firm changes its mix of debt and equity financing. These models provide guidance to financial managers as they consider changes in debt policy, estimate capital costs, or value corporate securities. Key insights include the following:

•As debt increases, shareholders require higher returns since they face higher financial risk. This higher financial risk results from spreading the firm's business risk over a proportionately smaller equity base. Equivalently, shareholders' risk increases as larger amounts of interest are committed to be paid to creditors from the firm's operating cash flows.

•The additional risk premium shareholders require for this additional financial risk increases directly with the firm's debt/equity ratio.

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