It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm because ________.
A) leverage decreases the risk of equity of the firm
B) leverage changes the unlevered cost of equity
C) leverage increases the risk of the equity of the firm
D) cost of debt decreases in this setting

Question

Quizplus · Accepted Answer

Leverage increases the risk of the equity of the firm because it introduces fixed financial obligations (interest payments) that equity holders are last in line to claim after debt holders. This increased risk demands a higher return, making it inappropriate to use the unlevered firm's cost of equity to discount cash flows of a levered firm.

It Is Not Correct to Discount the Cash Flows of a Levered