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

Ivan E Brick and Daniel G Weaver

Review of Quantitative Finance and Accounting, 1997, vol. 9, issue 2, 29 pages

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

Date: 1997
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