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in Multinational Corporations
by
NI = ROE * E
Deployed capital can, affected by an unfavourable (ROC = 2%), average (ROC = 6%), or favourable
(ROC = 14%) market development with equal probability, earn three different returns.
With a debt-equity ratio of 1 (D = E) and an interest rate on debt of i = 6%, the leverage equation gives
the following returns on equity:
With a higher debt-equity ratio, both the opportunity for a high return on equity and the risk of a low
(negative) return on equity increases simultaneously.
Shareholders:
Return on equity depends on the
debt level Risk but also potential reward increase with growing
level of debt.
3 Cases D/E 0/100 25/75 50/50 75/25
Lenders:
ROC < i Unfavourable 2% 0.67% -2% -10%
The arbitrage process would decrease the value of the levered firm
and increase the value of the unlevered firm, until both valuations
are again in equilibrium. Once again, investors are indifferent
between investment choices.
(3) The borrowing interest rate equals the lending interest rate
The value of the company is derived by discounting future cash flows with the weighted average cost
of capital (WACC).
If a company gradually increases its debt level, risk increases. This fact will either be neglected by
equity holders, or it seems to them to be negligible.
Future cash flows will be discounted with the same WACC. Thus, company value increases.
Only with a significant increase of the debt level – the exact threshold is unknown – equity holders
act on the increase of risk. Consequently, they require a higher return on equity, and future cash flows
are discounted with a higher WACC.
The question regarding the existence of an optimal capital structure is not unequivocally answered in
theory.