To better understand the effects of debt, which are related to the existence of tax deductibility, it is useful to first consider a world with a zero marginal tax rate. The usual formulas still apply, but the tax rate is set to zero. We will assume that given the risks of our simple firm and assuming the firm was entirely financed with equity, the beta of the equity would equal 0.80. This is the unleveraged beta referred to in Equation 1. Furthermore, we will assume the risk-free rate of return is equal to 6.0%. This is the same as the interest rate on debt, which implies that the debt is riskless.2 Finally, assume that the market risk premium is equal to 5.5%

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Based on the information provided lets consider a world with a zero marginal tax rate and analyze th... View the full answer