Changes in Cost of Equity Capital

The equity capitalization rate/cost of equity capital (ke) increases with the degree of leverage. The increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the increased risk, the shareholders would expect a higher rate of return on their investments. The increase in the equity capitalization rate (or the lowering of the price-earnings ratio, that is, P/E ratio) would match the increase in the debt-equitv ratio.

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