operating leverage (since they enjoy fewer economies of
scale).
Degree of Financial Leverage
Other things remaining equal, an increase in financial
leveragewillincreasetheequitybetaofafirm.Intuitively,we
wouldexpectthefixedinterestpaymentsondebttoincrease
earningspershareingoodtimesandtopushitdowninbad
times.
31 Higher leverageincreases the variance in earnings per
shareandmakesequityinvestmentinthefirmriskier.Ifallof
thefirm’smarketriskisbornebythestockholders(i.e.,the
beta of debt is zero),
32 and debt creates a tax benefit to the firm, then,
where
βL= Levered beta for equity in the firm
βu=Unlevered betaofthefirm(i.e.,thebeta ofthefirm
without any debt)
t= Marginal tax rate for the firm
D/E= Debt-to-equity ratio (in market value terms)
Intuitively, we expect that as leverage increases—as
measuredbythedebt-to-equity(D/E)ratio—equityinvestors
bearincreasingamountsofmarketriskinthefirm,leadingto