Assume a firm's debt is risk-free, so that the cost of debt equals the risk-free rate, Rf Define BA as the firm's asset beta- that is, the systematic risk of the firm's assets. Define B E to be the beta of the firm's equity. Use the capital asset pricing model (CAPM) along with M&M Proposition II to show that BE= BAx(1+D/E), where D/E is the debt-equity ratio. Assume the tax rate is zero.
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