(^282) Financial Management
shrinks. The optimum point is reached when the present value of the tax benefit
becomes equal to the present value of the costs of financial distress. The value of the
firm is maximum at this point.
CAMP and Capital Structure
Leverage causes variability in the shareholderí return (EPS or ROE). This adds
financial risk. As a consequence, the beta of a firmís equity will increase as it introduces
debt in its capital structure. We know that a portfolio consists of individual securities.
Each security has its beta, and the beta of the portfolio is the weighted average beta
of individual securities in the portfolio. Similarly, a firm is a portfolio of assets, and
therefore, the asset beta of a firm, P~I, is the weighted average of betas of individual
assets. Thus,
ba = b 1 w 1 + b 2 w 2 + b 3 w 3 + ....
ba = 

bv



  ...(29)

where ba is the weighted average beta of assets, Pi is the beta of ith asset and ......

is the weight of ith asset.

A firmís assets are financed by debt and equity. Therefore, a firmís asset beta will also

equal to the weighted average of the firmís equity beta and debt beta. Assuming no

corporate tax, the beta of assets will be as follows:

ba = bewe + bdwd ...(30)

where ... is equity beta, We is weight of equity, .... is debt beta and w, is weight of debt.

Weight of equity is equal to the market value of equity (S) divided by the total value

of the firm (V) and the weight of debt will be equal to the market value of debt (D)

divided by the total value of the firm (V).

Thus,

ba = be 

+

+b

+  



 




 ...(31)

What is beta of equity for a levered firm? We can derive equity beta from Equation

(31) as follows:

be 

+



= 

+

+b -b

 



 

be = ba 

^ +

+

-b

+