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Capital Structure and Cost of Equity

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In each of the theories of capital structure, the cost of equity rises as the amount of debt increases. So why don't financial managers use as little debt as possible to keep cost of equity down? After all, isn't the goal of the firm to maximize share value (and minimize shareholder costs)?

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Solution Summary

This solution of 317 words describes the importance of the cost of equity from a firms perspective and explains the goal of firm in maximizing shareholder cost.

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When debt rises as a proportion of capital, the firm becomes more levered and therefore riskier since it more likely to go into default from not being able to pay the higher interest amounts.

The cost of equity is a cost from the firm's perspective, a higher cost of equity means it means the shareholders will require a higher return to cover the higher risk of the firm going into default. From an investor's perspective, the higher cost of equity is the same as saying a ...

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