Abstract
One of the best-known Capital Asset Pricing Model (CAP/M) provides us with a methodology for measuring the relationship between the risk premium and the impact of leverage on expected returns. However, this model is not used only to value the cost of capital but also to evaluate the performance of managed portfolios. We will test how the expected return changes in percent by changing the debt-equity ratio and the tax rate based on following assumptions: market return 7%, risk-free rate of return 1% and beta 1.2. These assumptions will be constant and we will change the debt-equity ratio and tax rate. Based on these results, it is clear that the change in profitability varies, in relation to the change of the DE ratio by one tenth. As for changes I n tax rates, changes in expected profitability are not entirely in direct proportion to these changes.
Highlights
MethodsWe started with characteristics of the model
Leverage causes two problems: it increases the companys risk to shareholders and can cause the company to go bankrupt in bad times
We will test how the expected return changes in percentage by changing the debt-equity ratio and the tax rate based on the following assumptions: market return 7%, risk-free rate of return 1%, beta 1.2
Summary
We started with characteristics of the model. We used this model with variants by changing variables. These solutions are presented in tabular form. As companies in real life respond to the change in interest rates, we observed the four largest companies in the United States by market capitalization. We compared the DE ratio with the ROE ratio to prove whether the theory holds
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