Firm Valuation
Liquidation value: amount of cash you would receive if you sold separately the
various items that make up the firm's assets. It is the minimum price you would expect
to pay.
Replacement value: what it would cost today to replace an asset with a similar one
to start a new business with the same earning power as the one you wish to purchase.
It is the maximum price you would expect to pay for a tangible asset, but you may pay
more for intangible assets and assets that cannot be replaced.
Acceptable range: the range between the minimum value and the maximum value
that you would pay for an asset. A range of up to 10% is not unusual.
Valuing a private company
Valuing a company can be done by (i) valuation by comparables; (ii) discounted cash
flow method; (iii) liquidation value; (iv) replacement value.
EPS = EAT / ShareNo.
BVpS = BV / ShareNo.
P/E = SP/EPS
P/B = SP/BVpS
EBITDA = EBIT + Depreciation
Market Cap = SP * ShareNo.
EV = Market Cap + Debt – Cash
EV-to-EBITDA = EV/EBITDA
Firm 2 is private, similar to
public Firm 1.
You can assume that they have
the same:
- P/E: SP1/EPS1 = SP2 / EPS2
- P/B: SP1/BVpS1 = SP2 / BVpS2
- EV-to-EBITDA: EV-to-EBITDA1 =
EV2/EBITDA2
- Equity2 = EV2 + Cash2 – Debt2
Business assets: also called ‘operating assets’, assets used to operate the business;
they exclude cash and other financial assets.
To estimate the DCF value of a firm’s business assets (its Enterprise Value) we take
two inputs: (i) the stream of future cash flows the firm’s business assets are expected
to generate and; (ii) the discount rate that is required to get the present value of its
future cashflow stream. The stream of cashflows start with CF1 (generated at end of
year 1) and ends with CFT (terminal cash flow at the end of year T – usually 5 to 10
years in the future). We assume that the firm’s business assets generate cashflows in
perpetuity, so we must estimate the terminal value of the firm’s business assets at
time T. This terminal value is usually estimated by assuming that the cash flows after
year T will grow forever at a constant annual rate g: TVT = CFT+1 / (k-g) where k is the
firm’s WACC – note that this is not the PV.
Cost of equity kE of a private firm can be estimated by looking at a similar public firm.
CAPM can also be used to get an estimate of kE: kE = RFR + MRP*β
DCF Value of Equity = DCF Value of Business Assets + Cash - Debt
Little exercise: A firm is expected to generate next year FCF of $10 million expected to
grow by $2 million per year for following 4 years, and then by 3% per year in
perpetuity. The firm holds $10 million cash and has borrowed $100 million. Its cost of
capital is 8%.
TV5 = CF6 / (k-g) = 18*1.03/0.05 = 370.8 million
EV = sum of all discounted FCFs + TV5 = FCF1/(1+k) + FCF2/(1+k)2 + FCF3/(1+k)3 +
FCF4/(1+k)4 + FCF5/(1+k)5 + TV5/(1+k)5= 10/1.08 + 12/1.082 + 14/1.083 + 16/1.084 +
18/1.085 + 370.8/1.085 = 307
Equity Value = Enterprise Value + Cash – Debt = 307 + 10 – 100 = $217 million
Standalone firm: a firm that is managed ‘as is’ – without changing its operating or
financial performance.
Target Value: the value of a business after acquisition, assuming synergies
To assess the Target Value, we think about the ways in which we could improve the
business: (i) improve the assets’ operating efficiency (reduce the COGS/Sales,
SG&A/Sales or WCR/Sales ratio); (ii) grow the business faster (increase sales growth
rate); or (iii) reduce the cost of capital.
Value created by the interaction of improved operations with faster growth in sales:
(i) calculate the effect of each separately; (ii) calculate faster growth with the
improved operations; (iii) compare the values found.
Leveraged Buyout: a group of investors purchasing a presumably underperforming
firm by raising an unusually large amount of debt relative to equity. The major
difference between a potential merger and an LBO is that, unlike a merger, there are
no opportunities for synergistic gains in an LBO. All improved performance has to
come from better management of the firm and tax savings.
Project Valuation
When you seek to compare machines or projects of different lifespans, (i) calculate the
total PV of all cashflows, (ii) divide by the number of years. This allows you to calculate
the annuity equivalent cash flow.
Sunk costs should be ignored when calculating FCF of a Project.
Opportunity costs are profits a firm could have made had they chosen to pursue a
different project. They should be deducted from the annual cashflows the project is
expected to generate in the future – make sure to subtract the taxation you would have
incurred. If you forgo the opportunity to rent out a place for 50k, with a tax rate of 40%,
you should subtract 50k*.40 = 30k from annual cash flows.
WACC = D/(E+D) * kD * (1-T) + E/(E+D) * kE
Important: a firm’s cost of capital is its WACC even if that specific project can be financed
only with its debt.
Profitability Index: present value of expected future cash flow stream to its initial cash
outlay = PV Cash Flows / Cash Investment
Note: not additive, accept projects where PI > 1.
IRR Rule: accept projects where IRR > WACC. Note: not additive. When a project has
future negative cashflows it can have more than one IRR – so not reliable. Also, when
projects are mutually exclusive, IRR rule may not be reliable.
IRR = rate at which NPV = 0.
Payback Period = number of periods required for the sum of the project’s expected
cashflows to equal initial cash investment.
Where you have MEP with the same NPV, choose the one with the shortest payback
method
Discounted payback rule is same as payback rule, except with the PV of future expected
cashflows.
Free Cash Flows
1. WCR = Accounts Receivable + Inventories +
Operating Cash + Other Current Operating Assets –
(Accounts Payable + Other Current Operating
Liabilities) = 130 + 105 – 100 = 135
2. Change in WCR = WCR1 – WCR0 = 0.15*1000 – 135
= 150 – 135 = 15
3. CAPEX = Change in net fixed assets + Depr. = 500 –
490 + 0.02*1000 = 10 + 20 = 30
4. FCF = (Sales – Operating Expenses) * (1-T) + Depr. -
Change in WCR – CAPEX = (1000 – 0.92*1000) * (1 –
0.25) + 0.02*1000 – 15 – 30 = 80*.75 + 20 – 45 =
35
5. FCF = EBIT * (1-T) + Depr. – Change in WCR - CAPEX
Note: When Calculating WCR, make sure to state
whether you are assuming cash is operating cash or
not.
Time Value of Money
Compounding: the process of an investment earning interest on interest earned previously.
Compound Rate and Discount Rate are the same: k. Compound factor is CF=(1+k)T. Discount factor is DF=(1+k)-T.
Risk averse: investors that, all else being equal, prefer a risk-free cash flow to a risky cash flow with the same expected value.
Risk neutral: investors that are indifferent to risk.
Risk seeker: investors that prefer risky cashflows.
Discount rate for a risky cashflow: k = Riskless Rate + Risk Premium = rF + RP
Standard perpetuity: cashflow in which equal cash flows begin one year from now and continue indefinitely.
PV(Standard Perpetuity) = CF1/k
Immediate Perpetuity: a perpetuity in which equal cashflows start right now.
PV(Immediate Perpetuity) = CF0 + CF1/k
Deferred Perpetuity: perpetuity in which the equal cash flows start later than one year from now.
PV(Deferred Perpetuity) = [CFT/k] * [1/(1+k)(T-1)]
Growing Perpetuity: perpetuity in which the cashflows grow forever at a rate g.
PV(Growing Perpetuity) = CF / (k-g)
Annuity: cashflow stream with equal cash flows that lasts for T Periods.
PV(annuity) = CF * (1-DF)/k = CF * {[1 – (1+k)-T]/k}
PV(growing annuity) = CF/(k-g) * {1 – [(1+g) / (1+k)]T}
Annuity discount factor is ADF=(1-DF)/k
Future Value of an annuity: FV(Annuity) = CF * (1-DF)/k * (1+k)T
Bond Valuation and Risk
Bond: a certificate issued by a borrower that wishes to borrow money over a period of T years.
Term to maturity: the period of T years over which a bond has been lent.
Coupon Rate: the fixed annual interest rate of a bond.
Maturity Date: the date at which the principal of the bond will be repaid to the lender.
Yield-to-maturity: the discount rate that makes the bond price equal to the PV of the bond’s future CF stream.
Zero-coupon rate: also called spot rate, the yield-to-maturity of a zero-coupon bond.
Face value: also called the bond principal or redemption value, is the amount lent to the borrower.
Interest rate risk: the risk that the bond price may fail in response to a rise in interest rates, or the risk of
unexpected changes in bond prices caused by unanticipated changes in interest rates.
Credit risk: the risk that the issuer may not be able to pay the coupon and/or repay the principal. The risk that the
entity that issued the bond may be unable to pay the promised coupons and the bond’s face value in full and on
time, thus creating a potential loss to bondholders. Credit risk is measured by credit rating agencies.
Credit risk premium (CRP): additional yield demanded by bondholders to hold bons with credit risk: yield = RF + CRP
Undated Bond: a bond that does not have a maturity date and will pay coupons every year forever.
Zero coupon bond: a bond that pays no coupon – sold for less than face value and returns the face value on
maturity date.
Price of a 0-Coupon Bond = Face Value * Discount Factor = F*(1+k)-T
Price of a Coupon Bond = PV of Annuity + PV of FV = Coupon * (1-DF)/k + F*(1+k)-T = C * {[1 – (1+k)-T] / k} + F*(1+k)-T
Price of a Perpetual Bond = Coupon Payment / Discount Rate = Coupon Rate * Face Value / Discount Rate
Spot rate: y = (FV/P)1/T
Yield-to-maturity of a perpetual bond: y = Coupon/Price
Note: Bonds are not riskless. They have interest rate risk and credit risk.
There is an inverse relationship between the price and yield-to-maturity of a bond.
Duration of a coupon bond: a measure of a bond’s weighted average maturity. Note that the duration of a bond is a
function of its maturity, coupon rate and yield-to-maturity.
Duration of a zero-coupon bond is its term-to-maturity because a zero-coupon bond pays no coupons and does not
return any cash before the maturity date.
Duration of a perpetual bond = 1 + 1/yield-to-maturity
To calculate the duration of a coupon bond: (i) calculate each PV(CFi) at year i; (ii) % of Price = PV(CFi) / Price; (iii)
Dur = % of price * year i in which CFi occurs. Example: duration of a 2-year, 10% coupon bond with a $1,000 face
value assuming that the yield curve is flat at 5%: 100 in year 1, 1100 in year 2. PV(CF1) = 100/1.1 = 95.24; PV(CF2) =
1100/1.12 = 997.73; % of Price: PV(CF1)/1000 = 8.71%; PV(CF2)/1000 = 91.29%; Dur = 8.71% * 1 year + 91.29% * 2
years = 1.91 years.
Suppose you are a bond portfolio manager. You expect interest rates to fall. Would you modify the duration of your
portfolio? Yes, you would lengthen the portfolio’s duration because if rates go down, the value of the portfolio will go
up and the longer the portfolio duration is, the higher the increase in the value of your bond portfolio will be.
You manage a portfolio of bonds. You expect interest rates to rise. What should you do to minimize the impact of
your anticipated rise in rates on the value of your portfolio ? Shorten the average maturity of the bond portfolio and
raise the average coupon rate because you want the value of your portfolio to drop the least in response to your
anticipated rise in rates. And you know that this will happen when average maturity is the shortest and average
coupon rate is the highest.
To measure interest rate risk, calculate the price of a bond that will result from a given change in rates.
Maturity Effect: in general, if two bonds have the same coupon rate, then the bond with the longest maturity has
the most interest-rate risk.
Coupon Effect: in general, if two bonds have the same maturity, the bond with the lowest coupon rate has the most
interest-rate risk.
Bonds with different credit risk can have the same coupon rate if they were issued at a different date in the past
(see previous answer).

Risk Return & Diversification
Monthly returns: also called holding period return or realized return.
Monthly return = (Closing share price + dividends – closing share price of the
previous period) / closing share price of the previous period.
We measure the risk of shares with the variance of its returns (also called the
variability of a company’s returns). It captures the extent to which returns deviate
from their average value (see the numerical example in the previous page). The
larger the deviations, the higher the variance, and the higher is the risk of holding
the shares of the company. R is the average of a company’s returns over n periods,
and Ri the company’s actual returns for period i.
Variance of a company’s returns (s2) = [(R1 – R)2 + (R2 – R)2 +…(Rn – R)2] / (n - 1)
Standard deviation or volatility of returns (s) = ÖVariance
You can plot the position of a company in the risk-return plane below where the
horizontal axis indicates the risk of GTC's shares (measured either as the variance
or the standard deviation of GTC's returns) and the vertical axis indicates average
annualised returns (average returns * 12). GTC is identified as a point on the risk-
return plane.
Correlation coefficient: measure the strength of the co-movement between the
returns of the two assets.
When returns are perfectly positively correlated, the correlation coefficient takes
the value of +1. When returns are perfectly negatively correlated, the correlation
coefficient takes the value of -1. However, even if perfectly positively correlated, if
one stock goes up by 5%, you cannot tell by how much the other stock has gone up.
Portfolio risk of two stocks: sP2 = WA2sA2 + WB2sB2 + 2rAB * sA * sB * WA * WB
(WA + WB = 1)
Covariance of two stocks: sAB = rABsAsB
When a portfolio or a stock has the same risk as another asset but a higher expected
return we say that it dominates that asset.
Opportunity set: entire set of portfolios that
contain asset A and asset B in different
proportions, starting with 100% of wealth
invested in asset A and ending with 100% of
wealth invested in asset B.
The efficient portfolio is the one that maximizes returns for a given level of risk.
Here it would be any portfolio on the curved line from Portfolio P1 to Asset B.
As you increase the number of stocks in your
portfolio (up to 30), the risk of your portfolio
declines but does not go to zero because the
correlations between the returns of common
stocks are generally positive. It’ll get rid of the firm-
specific (or unsystematic) risk, but you cannot get
rid of market (or systematic) risk.
When two assets are perfectly correlated, their opportunity set is a straight line
between the two assets. When two assets are perfectly negatively correlated, their
opportunity set becomes two straight lines: one from the point at which 100% is
invested in asset A to the vertical axis (where 50% is invested in A and 50% in B),
and then another line from there until the point at which 100% is invested in asset
B.
In a portfolio of n assets, you have n(n-1)/2 distinct correlation coefficients.
Risk-free asset: an asset that has (i) zero volatility over the investment horizon and
(ii) zero correlation with other assets. The opportunity set for a risky asset and a
risk-free asset is a straight line between the two.
The efficient set of investments is any investment that starts at the risk-free asset
and passes through the tangent portfolio T.
Sharpe Ratio: the slope of the line connecting the risk-free asset to that asset on
the risk-return plane. It provides a measure of an asset’s excess return per unit of
risk. It is not a percentage.
Sharpe Ratio = E(RK) – RF / sK
Note that to achieve a certain return with a certain level of risk, you might need to
borrow at the risk-free rate and invest the amount borrowed in the risky asset. In
that case, WA or WB might be negative:
Example: consider an investor with $100,000 who wishes to achieve an expected
return of 10%. Describe the least risky portfolio that will achieve this target return.
The risk-free rate is 3% and the tangent portfolio has an expected return of 8% and
a volatility of 10%.
E[RP] = WA * E[RA] + (1 - WA) * RF ó E[RP] = WA * E[RA] - WA * RF + RF
WA * (E[RA] - RF) = E[RP] - RF ó WA = (E[RP] - RF) / (E[RA] - RF)
Where WA is the amount invested into the risky asset A and 1 – WA is the amount
borrowed (if negative) or invested (if positive) at the risk-free rate.
βU = 0.77; T = 40%; D = 800; EL = 1020. βL =
0.77 * [1 + (1 – 40%) * (800/1020)] = 1.13
The optimal amount of debt is an amount
equal to a little less than 100% of the
levered value of a firm’s assets. Industries
with tangible assets can afford higher
levels of debt due to lower business risk.
Trade-off theory of capital structure: theory
that posits that the potential costs associated
with financial distress or bankruptcy offset the
tax benefit of debt financing.
Capital Asset Pricing
Homogeneous expectations: all investors agree with the shape of the opportunity set of risky assets.
Capital Market Line: the straight line that starts at RF and goes through M. It represents the efficient set of portfolios
that combine the riskless asset and the market portfolio.
CML: E[RP] = RF + [(E[RM] – RF) / sM ] * sP
The segment of the CML between point F and point M indicates combinations of the market portfolio with lending at the
riskless rate (holding the riskless asset); the segment beyond point M indicates borrowing at the riskless rate to invest in
the market portfolio.
Example: RF = 4% E[RM] = 12% sM = 16% CML: E[RP] = 4% + 0.5sM
An investor has $100 invested efficiently. Her portfolio has a volatility of 20%. What is the composition of her portfolio?
E[RP] = 4% + 0.5*20% = 14% and WA = (E[RP] - RF) / (E[RM] - RF) = (14% - 4%) / (12% - 4%) = 10% / 8% = 1.25 – 125% invested
in the market portfolio and 25 borrowed at 4%.
Capital Asset Pricing Model requires the following assumptions (i) investors are risk averse; (ii) financial assets are
completely described by their expected return, their volatility and investors have homogeneous expectations; and (iii)
financial markets are perfect (no transaction costs; unique risk-free rate at which investors can either lend or borrow;
prices adjust instantly to new information).
Most assets are actually inefficient. All assets that are not a portfolio that combines the market portfolio (or an asset
perfectly correlated with the market portfolio) and the risk-free asset are inefficient.
Security Market Line: E[Ri] = RF + (E[RM] – RF) * βi
Note that this is also a firm’s equity cost of capital.
Excess return on the market portfolio, also called the risk premium, is E[RM] – RF.
Firm’s Beta: also called market risk or systematic risk, is a measure of the sensitivity of that
asset’s excess returns to the excess returns of the market portfolio. The firm’s beta is the
slope of the firm’s characteristic line. Note that the steeper the line, the higher the Beta.
Firm B’s Beta is 1.5. If the market portfolio’s expected excess return is 4%, B’s is 6%.
Beta can be calculated: βi = (ri,M * si * sM) / sM2 = ri,M * si / sM
What is the beta coefficient of a firm with a return volatility of 20% and a correlation coefficient of 0.60 with the market?
The volatility of the market returns is 16%. Beta = 0.60 * 20% / 16% = 0.75
βP = βA * W A + βB * W B + βC * W C
Firm A has a beta of 0.80, firm B a beta of 0.90, and firm C a beta of 1.20. You construct a portfolio by investing $5,000 in
shares of firm A, $3,000 in shares of firm B, and $2,000 in shares of firm C. The expected return on the market portfolio is
7% and the riskless rate is 2%. The portfolio has a beta of 0.8*5/10 + 0.9*3/10 + 1.2*2/10 = 0.91 and an expected return
of 2% + 5%* 0.91 = 6.55%.
The excess return of security A is 6% and its beta coefficient is 1.20. Security B has a beta of 0.90.
E[RA] – RF = 6% = (E[RM] – RF) * 1.20 ó E[RM] – RF = 6% / 1.20 = 5% and E[RB] – RF = (E[RM] – RF) * 0.9 = 5% * 0.90 = 4.50%
A firm’s cost of equity capital is an estimate of the rate of return expected by the firm’s shareholders on their equity
investment in the firm. kE = E[Ri] = RF + (E[RM] – RF) * βi
The Johnson Automotive Company (JAC) has an estimated beta coefficient of 1.20 and a volatility of 22%. The riskless rate
of return is 3% and the market portfolio has an expected return of 10% with a volatility of 12%. What is JAC’s estimated
cost of equity capital according to the CAPM? kE = 3% + (10% - 3%) * 1.20 = 11.40%
IIC has two divisions one with beta of 0.50 and one twice as large with beta of 1.10. The riskless rate of return is 3% and
the expected excess return on the market portfolio is 5%. Beta = 0.5*1/3 + 1.10 * 2/3 = 0.9 kE = 3% + 5%*0.9 = 7.5%. If
the division with the lower better wants to take on a project with an IRR of 7%, it should because that division’s cost of
equity is lower than the project – 3% + 5%*0.5 = 5.5%.
Capital Structure & Valuation
All-equity financed firm: a firm that does not borrow to finance its assets. VU = EU
Debt-financed firm: , a firm that uses both debt and equity to finance its assets. VL = EL + D
Enterprise Value: ‘VL’ or ‘VU’ market value of a firm’s assets. Three methods to calculate:
VU = EBIT * (1 - T) / kUE VL = (1) EL + D = (2) VU + T*D = (3) FCF / RWACC
The last formula assumes that the firm’s debt ratio remains constant.
Market Capitalization: ‘EL’ or ‘VU’ (VU = EU), market value of a firm’s equity. Three methods to calculate:
E = (1) VL – Debt = (2) PS × NS = (3) ECF/ kE
If a firm has $800 of debt at 5% interest, market cap of $1700, its VL is $2500. With 170 shares outstanding, its share price
is $10. Its capital structure can be measured with a debt ratio of 47% (Debt-to-Equity) or 32% (debt-to-assets).
A firm has perpetual EBIT of 250 and tax rate 40%. $800 of debt at 5% interest, so interest 40, taxable profit is 210. Tax
payments 84. If it had no debt, tax payment 100. Tax shield 16. If firm U wants the same capital structure, it can borrow
$800 to buy back its own shares. If the firm didn’t borrow, equity would be VU = EBIT (1 - T) / KUE = 1500. The firm does
borrow, so Equity is EL = VL – D = VU + T * D – D = 1500 +0.4 * 800 – 800 = 1020 and VL = 1820
Recapitalization: the process by which a firm changes its capital structure without changing its value.
Leverage recapitalization: the process by which an unlevered firm borrowing money to buy back its shares in the market
& change its capital structure without changing its value. Also known as a share repurchase program. Note: the firm will
buy back its shares at PL.
Perfect Capital Markets: markets that function (i) without any transaction costs and (ii) in which all market participants
have the same information about the value of assets.
Interest Tax Shield: a firm’s tax savings resulting from its borrowing. Note: worthless if (i) profits not taxed; (ii) pre-tax
loss; or (iii) interest payments are not tax-deductible. ITS = D * kD * T and PV (ITS) = T * D
Business Risk: the risk of holding unlevered equity (because equity is inherently risky). This means that EBIT by a company’s
assets cannot be known with certainty in advance.
Financial Risk: the risk of holding levered equity – additional to business risk.
Example: An all-equity firm has an EBIT of 250 and 0% tax rate. Business risk means that EBIT can be 200 or 300, with equal
probability. If it is 200, shareholders can expect a Return on Equity of 200/2500 = 8%. If it is 300, 12%. Average: 10%. Now
it borrows 800 at 5%. If EBIT = 200, ROE = (200 – 40) / (2500 – 800) = 9.4%. If EBIT = 300, ROE = 15.3%.
Equity Cash Flow: the cash flow that belongs to shareholders. ECF = (EBIT – (kD * D)) * (1 - T)
Example: Firm has EBIT of 250 with 800 debt at 5%. Tax rate is 40%. Annual ECF = (250 – (5% * 800)) * 0.6 = 126
Questions:
1. Does the choice of capital structure affect the value of a company’s assets ? MM Proposition I: the value of a firm’s
levered assets (VL) is equal to the value of its unlevered assets (VU) plus the present value of the future stream of
annual Interest Tax Shield (ITS). MMP I: VL = VU + PV(ITS) = VU + T * D
2. Is the share price when the firm borrows (PL) different from its share price if the firm does not borrow (PU) ? MM
Proposition I: the share price of a levered firm (PL) is equal to its share price if it did not borrow (PU) plus the present
value of the future stream of annual Interest Tax Shield (ITS) divided by the number of shares issued by the unlevered
firm (NU). PU = EU / NU and PL = PU + [PV(ITS) / NU]
Example: An all-equity financed firm has assets worth 1500 and 250 shares outstanding. PU = 1500/250 = 6. Now it borrows
800 at 5% and it is taxed 40%. PL = 6 + (0.4 * 800)/250 = 7.28. They can buy back 109 shares. Now they have 141 shares
outstanding at 7.28.
3. Is the cost of equity of the levered firm (kLE) different from the cost of equity of the unlevered firm (kUE) ?
MMP II: kLE = kUE + (kUE – KD) * (1 - T) * (D / EL) where kLE is the cost of equity for the levered firm, kUE the cost of equity
for the unlevered firm, KD the cost of debt, T the Tax Rate and EL the market capitalization of the levered firm.
Example: The shareholders expect a return of 10%. Tax rate is 40%. The firm borrowed 800 at 5%. Value of equity 1020. KLE
= 10% + (10% - 5%) * (1 – 40%) * 800 / 1020 = 12.35%
4. Is the WACC of the levered firm different from the WACC of the unlevered firm ?
MMP III: WACC = (D/VL) * kD * (1 – T) + (EL / VL) * kLE = kUE * [1 – T * (D/VL)]
WACC = kUE * [1 – (T *D / VL)] Note that you cannot use the WACC to value assets if the debt ratio changes.
Example: Firm borrowed 800 at 5%. VL = 1820. T = 40%. KLE = 12.35%.
WACC = 800/1820 * 5% * (1 – 40%) + 1020/1820 * 12.35%= 8.24%. WACC = 10% * (1 – (0.40 * 800 / 1820)) = 8.24%.
The relationship between a firm’s levered beta βL and its unlevered beta βU is given by the formula below which assumes
that debt is riskless (βD = 0). The tax rate is T and the firm’s debt to equity ratio is D/EL :
βL = βU * [1 + (1 – T) * (D/EL)] (which assumes βD = 0).