Response of The Cost of Equity To Leverage: An Alternative Perspective

Abstract

In this paper we examine the change in a corporation’s cost of equity asthe corporation increases leverage. Standard textbook treatments present the wellknownModigliani-Miller hypothesis that the cost of leverage increases linearly withincreases in the debt-to-equity ratio in keeping with a constant cost of capital for thefirm. Less frequently, textbooks present the Modigliani-Miller argument that, if thecost of debt rises with high levels of leverage, the cost of equity will increase at adecreasing rate or even decline in order to keep the overall cost of capital constant.Standard textbook presentations continue with additional discussions concerningtax effects and bankruptcy costs but without mention of the cost of equity. Thesepresentations leave the impression that the cost of equity remains as presentedin the Modigliani-Miller framework. In this paper we present theoretical andempirical arguments in support of our claim that the cost of equity increases slowlywith moderate increases in debt but increases dramatically as leverage increasessufficiently to cause equity investors to fear bankruptcy.