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Calculating the Cost of Capital of an Unlevered Firm for Use in Project Evaluation

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  • Brick, Ivan E
  • Weaver, Daniel G

Abstract

The adjusted present value requires an estimate of the cost of equity of an unlevered firm. Traditional approaches for calculating this cost assume that firms maintain a constant market-value percentage of debt when in fact firms typically use a book-value percentage of debt. In this paper, we present an approach to correctly estimate the cost of equity of an unlevered firm whenever the firm fails to maintain a constant market-value-based leverage ratio. We also demonstrate that both the Modigliani and Miller (1963) and Miles and Ezzell ( 1980) approaches may yield substantial valuation errors when firms determine debt levels based on book-value percentages. In contrast our method makes no errors as long as managers know the marginal tax benefit of debt. Copyright 1997 by Kluwer Academic Publishers

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  • Brick, Ivan E & Weaver, Daniel G, 1997. "Calculating the Cost of Capital of an Unlevered Firm for Use in Project Evaluation," Review of Quantitative Finance and Accounting, Springer, vol. 9(2), pages 111-129, September.
    • Handle: RePEc:kap:rqfnac:v:9:y:1997:i:2:p:111-29
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    Cited by:

    1. Robert Couch & Michael Dothan & Wei Wu, 2012. "Interest Tax Shields: A Barrier Options Approach," Review of Quantitative Finance and Accounting, Springer, vol. 39(1), pages 123-146, July.
    2. Ivan E. Brick & Hong-Yi Chen & Chia-Hsun Hsieh & Cheng-Few Lee, 2016. "A comparison of alternative models for estimating firm’s growth rate," Review of Quantitative Finance and Accounting, Springer, vol. 47(2), pages 369-393, August.
    3. Domingo A. Tarzia, 2016. "Properties of the financial break-even point in a simple investment project as a function of the discount rate," Papers 1611.03740, arXiv.org.
    4. Stefan Dierkes & Ulrich Schäfer, 2017. "Corporate taxes, capital structure, and valuation: Combining Modigliani/Miller and Miles/Ezzell," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 363-383, February.
    5. Domingo Alberto Tarzia, 2016. "Properties of the Financial Break-Even Point in a Simple Investment Project As a Function of the Discount Rate," Journal of Economic and Financial Studies (JEFS), LAR Center Press, vol. 4(2), pages 31-45, April.
    6. Groh, Alexander P., 2004. "Risikoadjustierte Performance von Private Equity-Investitionen," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 21382, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).

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