Hello again, Regarding this question, the expected returns on equity - in a tax free world, it is stated that the cost of borrowing would rise as debt outstanding increases, thus expected return on equity would rise to a certain point then tail off as higher borrowing costs bite. Wouldn't the expected return on equity get steeper as this happens to reflect the ever increasing risk??
Remove "expected" The actual return on equity will rise as gearing increases and then tail off as higher borrowing costs bite. The return on equity expected by investors will indeed continue to increase! The trick is that there are two different aspects of "return on equity" here - what they get and what they expect! Does that help?
