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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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Assume that the risk-free rate increases, but the market risk premium remains constant. What impact would this have on the cost of debt? What impact would it have on the cost of equity?

Summary Introduction

To identify: The impact on cost of debt and cost of equity if the risk-free rate increases but the market risk premium remains constant.

Introduction:

Risk-Free Rate:

Risk-free rate is the rate for an investment that has zero or no risk. This is the least return that an investor will look forward to receive from a risk-free investment for a period.

Explanation
  • If the risk free rate increases but the market price remains constant, then the required rate of return on the debt or the cost of debt will increase along with the risk-free rate.
  • Similarly, there will be an increase in the required rate of return on equity or cost of equity, if the risk–free rate increases market prices are kept constant.
  • The increase in risk free rate results in an increase in the cost of equity even if the market risk premium remains constant. The formula given below clearly shows the increase in risk free rate directly affect the required return on the equity.

Required Rate of Return on Debt Security=(Real Risk-free Rate+Inflation Premium

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