Chapter 10 PPT - Holthausen & Zmijewski 2019

Chapter 10
Levering and
Unlevering the
Cost of Capital
and Beta
© Cambridge Business Publishers 2019 1 Corporate Valuation 2e by Holthausen & Zmijewski
Discussion Topics
© Cambridge Business Publishers 2019 2 Corporate Valuation by Holthausen & Zmijewski

Levering and Unlevering Overview
 What is levering /unlevering all about?
 Comparable companies
 The unlevering process
 The levering process

What Is Levering / Unlevering All About?
 We use the unlevered cost of capital
 To discount free cash flows in an APV valuation
 To measure rWACC in a WACC valuation – either directly or
first measuring the equity cost of capital
 We do not observe the unlevered cost of capital unless
the company is all-equity financed
 To adjust for differences in financial leverage,
 Unlevering formulas measure the unlevered cost of capital
from the equity and other costs of capital of the comparable
companies and the company of interest
 Levering formulas measure the equity cost of capital from the
unlevered and other costs of capital
What Is Levering / Unlevering All About?
 Since the CAPM is a common way to measure

the cost of capital, we can first lever and unlever
betas and then measure the cost of capital
 Unlevering formulas measure the unlevered beta,
βUA, from the equity beta, βE, and other security
betas
 Levering formulas measure the equity beta, βE, from
the unlevered beta , βUA, and other security betas

 As long as the CAPM correctly measures the cost of
capital, levering and unlevering the cost of capital or
beta yield identical results
© Cambridge Business Publishers 2019 5
when properly done
Corporate Valuation by Holthausen & Zmijewski
Comparable Companies
 What is a good comparable company (comp) for
measuring the unlevered cost of capital?
 Do we care about differences in risk? Of course
we do
 What type of risk do we care about?
 As we discussed in Chapter 8, we care about
differences in business risk
 Revenue risk (co-variation with the economy)
 Operating leverage – fixed cost relative to variable
costs
Comparable Companies
 Do we care about differences in financial risk?
 For a company that is not in financial distress, we
can make adjustments for differences in financial
risk or leverage – this is the unlevering and levering
process
 For a company that is in financial distress, the
levering and unlevering process may not work as
well (more on this topic later)

The Unlevering Process
 We can unlever a comparable company’s equity cost of
capital or its equity beta, βE
 We perform this calculation to measure the unlevered
cost of capital from comparable companies
 We use the distribution of unlevered costs of capital or
betas of comparable companies to measure the
unlevered cost of capital or unlevered beta for the
company we are valuing


The Levering Process
 Once we measure the unlevered cost of capital or
beta for the company we are valuing, we can
measure its equity cost of capital or equity beta
 We do this by levering the unlevered cost of capital
or beta based on the characteristics of the
company’s capital structure taking into
consideration the company’s capital structure
strategy


The Discount Rate for
Interest Tax Shields, rITS
 The forms of the levering and unlevering
formulas depend on the assumption we make for
the discount rate for the interest tax shields
which in turn depends on how the company
manages its capital structure
 Before we develop the levering and unlevering
formulas, let’s first discuss the risk of interest
tax shields and the discount rate we use to value
them
Valuing Interest Tax Shields (ITSs)
 The discount rate for interest tax shields
(ITSs), rITS
 When to use the unlevered cost of capital for
rITS
 When to use the debt cost of capital for rITS
 Effect of interest deduction limitations or
caps

 How risky are ITSs? We know the cost of debt is
greater than the risk-free rate, so it is risky
 One can argue that the risk of ITSs is at least as risky as
debt, thus, the discount rate for ITSs is at least the cost
of debt
 Consider a company with perpetual debt and that has no plans
to change the amount of debt it has
 Does the cost of debt reflect the risk of the ITSs?
 Does the cost of debt reflect the risk of the company
capturing the tax benefit of the interest deduction?

Valuation of Interest Tax Shields

 If the appropriate discount rate VITS@rD, 0 = 
ITSt
 1+rD,t 
t
for ITSs is the cost of debt, the t 1
value of the ITSs is

 rD,t  VD,t  TINT,t
= 
 1+rD,t 
t
t 1
 If the debt is perpetual and the ITS

VITS@rD 
amount will not change and if rD
the cost of debt is constant and
the relevant tax rate is constant rD  VD  TINT
=
rD
and the firm is not expected to
grow or decline then
 TINT  VD (10.1)
 Can ITSs be more risky than reflected in the cost of
debt?
 Consider a company with a substantial amount of debt
that matures in 5 years
 What factors determine if the company will be able to
refinance that debt in 5 years?
 What will happen if the company’s performance declines
substantially during the next five years?
 What will happen if the company is growing during the next
five years – will the company want to issue additional debt?

 Consider the extreme case of a company that
continually refinances itself to a constant capital
structure ratio of, say, 30%
 If the value of the firm increases, the company will
issue more debt
 If the value of the firm decreases, the company will
reduce its debt
 How risky is this company’s ITSs?
 Does the risk of the company’s assets reflect the risk in
this company’s ITSs?

 If the appropriate discount rate VITS@rUA, 0 = 
ITSt
 1+r 
t
t 1
for ITSs is the unlevered cost of UA,t
capital, rUA, the value of the  rD,t  VD,t  TINT,t

= 
ITSs is  1+r 
t
t 1
UA,t
ITS
VITS@rUA 
 If the debt is perpetual and the rUA
amount will not change – but rD  VD  TINT

=
does rUA seem right in this case? rUA
 Which of the two discount rates

result in the higher value for
 The extreme cases – perpetual no-growth debt and
continually refinancing to a fixed capital structure –
provide a way to set boundaries on the discount rate for
ITSs, rD ≤ rITS ≤ rUA
 We can think of many situations where the discount rate
for the interest tax shields of a company is not the same
for all the interest tax shields of the company
 For example, we might use the cost of debt to discount
ITSs for existing debt but use the unlevered cost of
capital to discount ITSs for refinanced or additional
debt
When to Use
rD = rITS versus rUA = rITS?
 Guiding principles for choosing the discount rate for
ITSs are
 In the long run, it is unlikely that the amount of debt a company
will issue will be independent of the company’s value
 For existing debt that is managed independent of the value of
the firm use the cost of debt to discount ITS
 For companies pursuing a target debt/value capital structure
policy, use the unlevered cost of capital to discount ITSs
 In a recent survey 10% of the companies had very strict target
debt ratios, 34% had a strict target range, and 37% had a
flexible target range

Annual Refinancing
 Companies never refinance to a target capital structure
continuously – does the choice of discount rate change
if a company refinances annually?
 Since the company has debt in place for the next year
(Year 1)
 The cost of debt better reflects the risk of the ITS in Year 1
 For Year 2, the amount of debt depends on the value of the
firm at the end of Year 1, but once that debt is fixed at the end
of Year 1, it no longer depends on the value of the firm
 Use the cost of debt to discount Year 2 ITS from Year 2 to
Year 1, then use the unlevered cost of capital to discount Year
2 ITS from Year 1 to Year 0

Annual Refinancing
 Assume a company refinances its debt annually to a
25% debt to value ratio
 Cost of debt is 10%, unlevered cost of capital is 12% and the
tax rate is 40% on all income
 Year 0 debt outstanding is $1,200
 The expected value of the firm at the end of Year 1 is $6,000
 What is the value of the ITSs for Years 1 and 2?
VD
rD  VD, 0  TINT rD  VF, 1  T
VF INT
VITS, 0  
1+ rD  1+ rD    1+ rUA 
.1 $1, 200  .4 .1 $6,000  .25  .4

VITS, 0    $102
1.1 1.1 1.12
with Annual Refinancing
 More generally, for each ITS
 Discount the ITS for the last year of the ITS at the cost of
debt
 Discount the ITS for all remaining years at the unlevered cost
of capital
 This results in the following valuation formula
 Key thing to note is that as of time 0, the risk of all the

tax shields except the first year is based on rUA

Interest Deduction Limitations (Caps)
 Recall from Chapter 3, some countries limit the amount of interest
a company can deduct for income tax purposes
 Interest deduction caps can affect the expected amount and
riskiness (discount rate) of interest tax shields
 Interest deduction caps in the U.S. and the U.K. are a function of
the company’s performance (for example, a percentage of
EBITDA), which makes the risk of the interest tax shields a
function of the risk of the company’s performance (rUA)
 Any limitation on the deduction of interest that is a function of the
company’s performance has the potential to increase the riskiness
of the tax shield relative to a tax regime with no interest deduction
cap

Levering the Cost of Capital
 Recall the levering process
 The economic balance sheet revisited
 The general levering formula
 Choosing a levering method
 More on the weighted average cost of capital
 Levering beta, β


Some Underlying Assumptions
 Assume
 Value from financing is equal to the value of a company’s interest
tax shields, VITS (VFIN = VITS)
 The present value of a company’s expected interest tax shields –
discounted at the appropriate discount rate – captures the entire
effect of financial leverage on the value of the firm – potential
effects of financial distress, bankruptcy costs, agency costs, and
personal income taxes have no significant impact on the value of
debt financing
 No shifts in economy-wide expected rates of return due to
changes in economic conditions, such as shifts in inflation or
shifts in the required real rate of return on a riskless asset
demanded by investors (but we can easily allow this)
The Economic Balance Sheet
 Recall that the value of the firm (resources) is equal to
the value of the securities used to finance the firm
(claims on resources)
 The dollar expected return on the firm’s resources is

equal to the dollar expected return on the claims
 Isolate the equity cost of capital

The General Levering Formula
 We can restate that formula to derive our general levering
formula

The General Levering Formula
 The starting point for the equity cost of capital is the unlevered
cost of capital – all equity financed, rE = rUA
 Increase rE for non-common equity financing that have fixed
claims with higher priority over equity claims
 The equity cost of capital increases with debt financing
 The equity cost of capital increases with preferred stock financing
 Decrease equity cost of capital if the discount rate for ITSs is
less than the unlevered cost of capital
 We can also allow for terms for equity-linked securities like
stock options and warrants – those terms will look like the
preferred stock term
Alternative Assumptions for the
Discount Rate for Interest Tax Shields
 How does the levering formula change if we

assume?
 Discount all ITSs at the unlevered cost of capital
 Discount all ITSs at the debt cost of capital
 Issue perpetual debt and discount ITSs at debt cost of

capital
 Annual refinancing – discount all ITSs at the debt
cost of capital for one period and at the unlevered
cost of capital for all other periods
Levering Formula When rITS = rUA
 Discount all ITSs at the unlevered cost of capital, rUA
 What if interest is not tax deductible?

 V ITS = 0, same formula as 10.5
Levering Formula When rITS = rD
 Discount all ITSs at the debt cost of capital, r D

Levering Formula for
Perpetual No-Growth Debt
 For perpetual, no growth debt, discount all ITSs at the debt
cost of capital, rD
where VITS =( TINT x VD x rD)/rD= TINT x VD

Levering Formula for Annual Refinancing
to Rebalance to Target Capital Structure
 Assume annual refinancing – discount all ITSs at the debt cost of
capital for one period and at the unlevered cost of capital for all
other periods, but at time 0 only the first year ITS has a risk of rD
 This formula is similar to the formula for discounting all ITSs at

the unlevered cost of capital
 Assume TINT = 50%, rD = 12% (both relatively high rates), then the
adjustment is equal to .95 = 1 – [(.12 x .5)/1.12]
Example – The U Lever It Company
 The U Lever It Company is a privately held company
 Target capital structure strategy of 50% debt, 10% preferred
stock, and 40% equity
 Cost of debt is 8% and its cost of preferred stock financing is
9%, unlevered cost of capital is 12%
 Income tax rate is 40% on all income
 Expected unlevered free cash flows are $1,000 in perpetuity –
company holds no excess cash
 What is the company’s
 Equity cost of capital?
 Weighted average cost of capital?
 Value of the firm and value of the interest tax shields?
U Lever It Example – rITS = rUA
.5 .1
rE  .12   .12  .08     .12  .09    .1775
.4 .4
rWACC =.1775×.4 + (1  .4)×.08×.5 + .09×.1=.104
FCF1 $1,000
VF  VF   $9,615.38
rWACC .104
FCF1 ITS1 $1,000 .08  $9,615.38  .5  .4
VF   VF    $9,615.38
rUA rUA .12 .12
rD  VF, 0 
VD
 TINT  $8, 333.33  $1, 282.05  $9,615.38
FCF1 VF
 
rUA rUA

U Lever It Example – rITS = rD
(fixed amount of perpetual debt)
.5 .1
rE  .12   .12  .08    1  .4     .12  .09    .1575
.4 .4
rWACC =.1575 ×.4 + (1  .4)×.08×.5 + .09×.1=.096
FCF1 $1,000
VF  VF   $10,416.67
rWACC .096
$1,000 .08  $10,416.67  .5  .4
FCF1 ITS1 VF    $10,416.67
VF   .12 .08
rUA rD  $8,333.33  $2, 083.33  $10,416.67
VD
rD  VF, 0   TINT
FCF1 VF
 
rUA rD

U Lever It Example – rITS = rUA versus rD
rITS = rUA rITS = rD
$1,000 $1,000
VF   $9,615.38 VF   $10,416.67
.104 .096
$1,000 .08  $9,615.38  .5  .4 $1,000 .08  $10,416.67  .5  .4
VF    $9,615.38 VF    $10,416.67
.12 .12 .12 .08
 $8,333.33  $1, 282.05  $9,615.38  $8,333.33  $2, 083.33  $10,416.67
 VITS is 13% of the value of the  VITS is 20% of the value of the
firm firm
 Unlevered value is unaffected  VF is 8% higher assuming rITS
by the choice of discount rates = rD versus rUA
for ITSs
What If Interest Is Not Tax Deductible?
 The levering formula is the same as the levering
formula using the unlevered cost of capital to
discount ITSs
 Thus, the equity cost of capital is the same as the
equity cost of capital using the unlevered cost of
capital to discount ITSs if you are holding the
proportions of the capital structure constant.
 Is the valuation the same?

U Lever It Example – Interest Is
Not Tax Deductible
.5 .1
rE  .12   .12  .08     .12  .09    .1775
.4 .4
rWACC =.1775×.4 + (1  0)×.08×.5 + .09×.1=.12
FCF1 $1,000
VF  VF   $8,333.33
rWACC .12
 Without the tax benefit from ITS, the rWACC is equal to the
unlevered cost of capital, regardless of the capital structure
 The equity cost of capital depends on the capital structure but the
weighted average cost of capital does not
 In this case, the value of the firm is equal to the unlevered value of
the firm
Recall Annual Refinancing
 Since the company has debt in place for the next
year (Year 1)
 The cost of debt better reflects the risk of the ITS in
Year 1
 For Year 2, the amount of debt depends on the value
of the firm, but once that debt is fixed at the end of
Year 2, it no longer depends on the value of the firm
 Use the cost of debt to discount Year 2 ITS from
Year 2 to Year 1, then use the unlevered cost of
capital to discount Year 2 ITS from Year 1 to Year 0

More on Annual Refinancing
 More formally
ITS1 ITS2 ITS3 ITS4
VITS, 0      
1+ rD  1+ rD    1+ rUA   1+ rD    1+ rUA  2
 1+ rD    1+ rUA 
3
 If ITSs grow at a constant rate

ITS1   1+g  ITS1   1+g  ITS1   1+g 
2 3
ITS1
VITS, 0      
1+ rD  1+ rD    1+ rUA   1+ rD    1+ rUA  2  1+ rD    1+ rUA  3
ITS1 ITS1   1+g  ITS1   1+g  ITS1   1+g 

2 3
1+ rD
VITS, 0       
 1+ rUA   1+ rUA   1+ rUA 
2 3 4
1+ rUA 1+ rUA
1+ rD ITS1 ITS1 1+ rUA

VITS, 0   VITS, 0  
1+ rUA rUA  g rUA  g 1+ rD

U Lever It Example – Annual Refinancing
 .08  .4  .5 .1
rE  .12   .12  .08   1      .12  .09    .1760
 1.08  .4 .4
rWACC =.1760×.4 + (1  .4)×.08×.5 + .09×.1=.1034
FCF1 $1,000
VF  VF   $9,670.49
rWACC .1034074
FCF1 ITS1 (1  rUA ) VF 

$1,000

.08  $9,670.49  .5  .4 1.12
  $9,670.49
VF    .12 .12 1.08
rUA rUA (1  rD )
 $8,333.33  $1, 337.15  $9,670.49
VD
rD  VF, 0   TINT
FCF1 VF (1  rUA )

rUA

rUA

(1  rD )
Unless TINT and rD are large,
annual financing and rITS = rUA
result in similar valuations
Choosing a Levering Method
 Determined by the choice of the discount rate for the
interest tax shields which is based on the capital structure
strategy of the firm – same guiding principles
 For existing debt that the company does not intend to retire
early, use the cost of debt to discount ITS
 In a recent survey 10% of the companies had very strict target
debt ratios, 34% had a strict target range, and 37% had a
flexible target range

How Does rWACC Embed the Value of
Interest Tax Shields in a Valuation
 Note how the WACC DCF was able to handle
multiple ways of valuing the interest tax shields –
at rD at rUA and a combination of the two for every
interest tax shield.
 How???? We observe two effects
 The directly observed effect is through measuring the
cost of debt on an after tax basis (1-TINT) x rD
 The indirect effect is through the equity cost of
capital, which depends on the value and risk of the
interest tax shields
More on Interest Tax Shields and rWACC
 We can see this effect if we begin with our standard
formula to measure rWACC
 Substitute the general levering formula for the rE in the

formula for rWACC
 The resulting formula for the weighted average cost of

capital is
More on Interest Tax Shields and rWACC
 For rITS = rUA
 For rITS = rD
 For zero-growth, perpetual debt with rITS = rD


Levering Beta, β
 The Capital Asset Pricing Model (CAPM) is a widely
used method of estimating the cost of capital
 Instead of unlevering the equity cost of capital, many
practitioners
 Estimate the equity beta of the comparable companies, βE
 Unlever the equity beta, βE, to measure the unlevered beta, βUA
 Use the unlevered beta, βUA and the CAPM to measure the unlevered
cost of capital, rUA, for the company being valued if using the APV
method
 Or relever the unlevered beta, βUA, to measure the equity beta, βE, and
then measure the equity cost of capital, rE, using the CAPM for the
company being valued. Finally, we measure the weighted average cost
of capital, rWACC for the company being valued

Levering Beta, β
 The levering formulas for beta are the same as the
levering formulas for the cost of capital – substitute beta
for each cost of capital (except for one spot in annual
refinancing)
rF + β E  E(R m )  R F  = rF + β UA  E(R m )  R F 
 V
 rF + β UA  E(R m )  R F   rF + β D  E(R m )  R F   D
VE

      
+ rF + β UA  E(R m )  R F   rF + β PS  E(R m )  R F  
VPS
VE

 V

 rF + β UA  E(R m )  R F   rF + β ITS  E(R m )  R F   ITS
VE
Levering Beta, β
 Subtract rF from each side of the equation
 Divide by the market risk premium (R m – RF)
rF + β E  E(R m )  R F  = rF + β UA  E(R m )  R F 
 V
 rF + β UA  E(R m )  R F   rF + β D  E(R m )  R F   D
VE

 V
+ rF + β UA  E(R m )  R F   rF + β PS  E(R m )  R F   PS
VE


 rF + β UA  E(R m )  R F   rF + β ITS  E(R m )  R F  
 
VE

VITS
VD V V
β E = β UA   β UA  β D   +  β UA  β PS   PS   β UA  β ITS   ITS
VE VE VE
The Levering Formulas for β

Using the CAPM to Measure Beta
from an Observed Cost of Capital
 Recall the CAPM
 If we have a company’s cost of capital for any security,

we can use the CAPM to measure the security’s implied
beta
 Use the same risk free rate and MRP as you are using in
your implementation of the CAPM
©
We estimate the beta for debt
Cambridge Business Publishers 2019 56
and preferred stock this
Recall The U Lever It Company
 The U Lever It Company is a privately held company
9%, unlevered cost of capital is 12%
 The risk-free rate is 5% and the market risk premium is
7%
 What is the company’s
 Equity beta and equity cost of capital?
 Value of the firm and value of the interest tax shields?

U Lever It Example – Betas
 Use the cost of capital, the risk-free rate and the
market risk-premium to measure beta from the
CAPM
 Unlevered beta, βUA = (12% ̶ 5%)/7% = 1.0
 Debt beta, βD = (8% ̶ 5%)/7% = .429
 Preferred beta, βPS = (9% ̶ 5%)/7% = .571

.5 .1
β E  1   1  .429     1  .571   1.821
.4 .4
rE = rF +β E  (R M  R F )
rE =.05  1.821×.07=.1775

U Lever It Example – rITS = rD
(fixed amount of perpetual debt)
.5 .1
β E  1   1  .429    1  .4     1  .571   1.536
.4 .4
rE = rF +β E  (R M  R F )
rE =.05  1.536×.07=.1575

U Lever It Example – Annual Refinancing
 .08  .4  .5 .1
β E  1   1  .429   1      1  .571   1.8
 1.08  .4 .4
rE = rF +β E  (R M  R F )
rE =.05  1.8×.07=.176

Unlevering the Cost of Capital
 Recall the unlevering process
 The general unlevering formula
 Choosing an unlevering method


The General Unlevering Formula
 We begin with the return on the economic balance sheet
 Isolate the unlevered return on the left side of the

equation:
VE V V V
rUA = rE  + rD  D + rPS  PS  rITS  ITS
VUA VUA VUA VUA

Unlevering Formula When rITS = rUA
VE V V V
VUA VUA VUA VUA
VITS VE VD VPS
rUA  rUA  = rE  + rD  + rPS 
VUA VUA VUA VUA
VE VD VPS
VUA VUA VUA
rUA = rE  + rD  + rPS 
VUA  VITS VUA  VITS VUA  VITS
VUA VUA VUA

Unlevering Formula When rITS = rUA
VE VD VPS
VUA VUA VUA
rUA = rE  +r  +r 
VUA  VITS D VUA  VITS PS VUA  VITS
VUA VUA VUA
VE VD VPS
rUA = rE  + rD  + rPS  (10.14)
VF VF VF

Unlevering Formula for
 For perpetual, no growth debt, discount all ITSs at the
debt cost of capital, rD
 Value of ITSs, VITS = TINT x VD
VE V V V
VUA VUA VUA VUA
VE VD VPS TINT  VD
rUA = rE  + rD  + rPS   rD 
VF  TINT  VD VF  TINT  VD VF  TINT  VD VF  TINT  VD
VE VD VPS
rUA = rE  + rD   1  TINT   + rPS  (10.16)
VF  TINT  VD VF  TINT  VD VF  TINT  VD

 We can rearrange equation 10.16 so that we only need to
know the capital structure ratios
VE VD VPS
rUA = rE  + rD   1  TINT   + rPS  (10.16)
VF  TINT  VD VF  TINT  VD VF  TINT  VD
VF  TINT  VD V V
rUA = rE + rD   1  TINT   D + rPS  PS
VE VE VE
VE  VD  VPS  TINT  VD V V
rUA  = rE + rD   1  TINT   D + rPS  PS
VE VE VE
 V V  V V
rUA  1   1  TINT  D  PS  = rE + rD   1  TINT   D + rPS  PS
 VE VE  VE VE

 We can rearrange equation (10.16) so that we only need to
know the capital structure ratios
 V V  V V
rUA   1   1  TINT  D  PS  = rE + rD   1  TINT   D + rPS  PS
 VE VE  VE VE
VD V
rE + rD   1  TINT   + rPS  PS
VE VE
rUA = (10.16 ')
VD VPS
1   1  TINT  
VE VE

Cost of Capital Unlevering
Formulas

Beta, β, Unlevering Formulas

The Comp Co. Example
 The Comp Company is a publicly held company that
will be used as a comparable company in a valuation
9%
 Equity beta and cost of capital are, 1.6667 and 14%
 Risk-free rate is 4% and the market risk premium is 6%
 What is the company’s unlevered beta and cost of
capital, βUA, rUA?

The Comp Co. Example– Betas
 Use the cost of capital, the risk-free rate and the
market risk-premium to measure beta from the
CAPM
 Debt beta, βD = (8% ̶ 4%)/6% = .6667
 Preferred beta, βPS = (9% ̶ 4%)/6% = .8333

The Comp Co. Example – rITS = rUA
VE V V
rUA = rE  + rD  D + rPS  PS (10.14)
VF VF VF
rUA = .14  .3+ .08  .5+ .09  .2  .1
VD V
βE + βD  + β PS  PS
VE V V VE VE
β UA = β E  + β D  D + β PS  PS (10.18) β UA = (10.18')
VF VF VF V V
1+ D + PS
VE VE
β UA  1.6667  .3  .6667  .5  .8333  .2  1.0
rUA  .04  1.0  .06  .1

No Growth Perpetuity, rITS = rD
VD V
rE + rD   1  TINT   + rPS  PS
VE VE
rUA = (10.16 ')
VD VPS
1   1  TINT  
VE VE
.14  .08   1  .4   .5  .09  .3
rUA   .105
1   1  .4   .5  .3
VD V
β E + β D ×  1-TINT  × + βPS × PS
VE VE
β UA  (10.20 ')
VD VPS
1+  1-TINT  +
VE VE
1.6667  .6667   1  .4   .5  .83333  .3

β UA   1.0833
1   1  .4   .5  .3
rUA  .04  1.0833  .06  .105

Annual Refinancing
 .08  .4 
.14  .08  1    .5  .09  .3
rUA   1.08   .1003
 .08  .4 
1  1    .5  .3
 1.08 
 .08  .4 
1.6667  .6667  1    .5  .83333  .3
 1.08 
β UA   1.005
 .08  .4 
1  1    .5  .3
 1.08 
rUA  .04  1.005  .06  .1003

Choosing a Unlevering Method
 The same guiding principles we use for choosing a
levering method can be used for selecting an unlevering
formula
 Different comparable companies can have different
discount rates for ITSs, thus, different unlevering
formulas may be appropriate in valuing a single company
with multiple comparable companies
Using Comparable Companies to
Estimate Beta

Using Comparable Companies
to Estimate Beta
 We typically use comparable companies to help
estimate the cost of capital
 In the portfolios constructed for Exhibit 8.1 (portfolios
from 1 to 125 securities – 1000 replications of each)
 The average standard error for one security = 0.26
 The average standard error for five securities = 0.13
 The average standard error for ten securities = 0.10
 Thus, if the beta estimate was 1.0, the 95% confidence

interval goes from 0.48 to 1.52 with one security to 0.80
to 1.2 with ten securities
 We use comparables to improve our precision
Estimate Beta
 We begin by choosing close competitors and look
for any indication that the potential comparable
company might have different revenue cyclicality
or different operating leverage (variable to fixed
costs)
 Close competitors using different business models
can have different risks
 A restaurant chain that leases all its stores vs. a
restaurant chain using a franchise model
 A steel minimill operator vs. a large integrated steel
plant
Estimate Beta – The Process
 Estimate each comparable company’s costs of debt,
preferred, equity and capital structure
 Want to measure these over the beta estimation period
 Estimate each comparable company’s unlevered beta
 Find measure of central tendency
 If using APV method, use the unlevered beta in conjunction
with the CAPM to measure the unlevered cost of capital
 If using WACC method, lever up the unlevered beta based on
the company’s anticipated capital structure to determine the
equity beta, estimate the equity cost of capital using the CAPM
and then solve for the companies rWACC

Estimate Beta
 We could use an equal or weighted average unlevered beta or
percentile in the distribution
 Could also use the precision of the unlevered beta estimates to
weight the betas, using the standard errors of the unlevered betas
for weights, called a precision weighted beta
N  1 
 βi 
 

βPrecision Weighted =
i=1  SE ,βi  (10.22)
N 
1 
 

i=1  SE ,βi 

 Where σSE, βi is the standard error of company i’s unlevered

beta.
 The standard error of the unlevered beta, σSE, βi, is the standard
error of the equity beta * (VE/VF)
Estimate Beta
 Vasicek developed another adjustment technique to
adjust beta toward the mean of a specified portfolio’s
beta
 The adjustment is a function of how noisy the beta estimate is
for the individual firm relative to how much variation there is
in the betas from a comparable
 β2 companies
 SE,β
2
or other portfolio
Vasicek Adjusted βi = P
βi  i
β P (10.23)
 2
SE,βi
 2
βP
 2
SE,βi
  β2
P
 Where σ2SE, βi is the variance of company i’s beta, σ2SE, βp is the

variance of the portfolio, βi and βp and are the beta of the
company and the mean beta of the portfolio of comparable
companies, respectively
 Could adjust to the market or to chosen comparables
Example Using Comparable Companies
to Estimate Beta
 Calculate the precision weighted beta and the Vasicek
adjusted beta using the four comparable companies and
the company being valued, assuming all of the betas are
unlevered
Standard
Beta Error of
Estimate Beta t-statistic
Comparable Company #1 0.800 0.400 2.00
Company Being Valued 1.400 0.300 4.67

Estimate Beta
 Precision weighted beta
 Where σSE, βi is the standard error of company i’s unlevered
beta.
 The standard error of the unlevered beta, σSE, βi, is the standard
error of the equity betaN * (VE/V

1 F
)
β i 


βPrecision Weighted =
i=1  SE ,βi  (10.22)
N 
1 
 

i=1  SE ,βi 

1 1 1 1 1
0.8   0.9   1.3   1.5   1.4 
βPrecision Weighted = 0.4 0.2 0.5 0.4 0.3  1.142
1 1 1 1 1
   
0.4 0.2 0.5 0.4 0.3

Estimate Beta
 Vasicek adjusted beta, where
 σ2SE, βi is the variance of company i’s beta, 0.09
 σ2SE, βp is the variance of the portfolio, 0.0819
 βi is the beta of the company being valued, 1.4
 βp is the mean beta of the portfolio of comparable companies,
1.125
 β2  SE,β
2
Vasicek Adjusted βi = P
βi  i
β P (10.23)
 2
SE,βi
 2
βP
 2
SE,βi
 2
βP
0.0819 0.09
Vasicek Adjusted βi = 1.4  1.125 1.256
0.09  0.0819 0.09  0.0819

Example Using Comparable Companies
to Estimate Beta
Standard Bloomberg
Beta Error of 1/ Standard Adjusted
Precision Weighted Beta: Estimate Beta Error Beta
Comparable Company #1 0.800 0.400 2.500 0.866
Company Being Valued 1.400 0.300 3.333 1.268
Comparable Company Average Beta 1.125

Comparable Company Median Beta 1.100
Average Beta of Comps and Company Being Valued 1.180

Median Beta of Comps and Company Being Valued 1.300
Precision Weighted Beta 1.142

Sum of 1/ Standard Error 15.333
Vasicek Adjusted Beta - Company Being Valued 1.256
Variance of the Comparable Company Betas 0.0819

Standard Error Squared - Company Being Valued 0.0900
Weight for Company Being Valued 0.4764
Weight for Comparable Company Portfolio Beta 0.5236

Financial Distress Costs
 Our framework for levering and unlevering does
not control for financial distress costs
 To the extent financial distress costs are
embedded in the various costs of capital, the
unlevering formulas do not adjust for those costs
 Implications
 When valuing companies with modest leverage and
no financial distress costs, do not use highly levered
comps
 When valuing companies experiencing financial
distress, may be more appropriate to use more highly
levered comps
Avoiding Common Errors
 Incorrect use of Modigliani and Miller’s
formula
 The effect of assuming zero beta for debt and
preferred stock (and other securities used to
finance the company)
 Ignoring equity-linked securities used to
finance the company (Chapter 12)

Incorrect Use of the M&M Formula
 The dominant method used to unlever and lever the cost of
capital (or betas) continues to be the basic approach
developed by M & M, widely known as “M&M with
taxes” (the perpetual debt assumption)
 We also know that in most valuations, we expect the
company to grow and issue debt for growth or to refinance
existing debt to maintain its target capital structure ratios
 Thus, the appropriateness of the M&M with taxes
equations depends on how close the value and risk of the
company’s interest tax shields are to the assumed value and
risk in M&M with taxes
Incorrect Use of the M&M Formula
 Assume a company
 Has an expected unlevered free cash flow in Year 1 and every
year thereafter of $1,140 (no growth)
 Its unlevered cost of capital is 15%
 Its target capital structure is 60% debt and 10% preferred stock,
its cost of debt is 10%, its cost of preferred stock is 11%
 Its tax rate on all income is 40%
 What is the
 Equity cost of capital?
 Value of the firm and equity?

Using the M&M Formulas for
a No-Growth Perpetuity
VD V
 This is a no- rE = rUA   rUA  rD    1  TINT  
VE
+  rUA  rPS   PS
VE
(10.7)
growth rE  .15   .15  .1   1  .4   2   .15  .11  .333  .2233
perpetuity
VE VD V
rWACC = rE + rD  1 - TINT  + rPS PS (5.6)
 The equity, VF VF VF
rWACC  .2233  .3  .1   1  .4   .6  .11 .1  .114
weighted
or
average cost  V 
rWACC = rUA  1  TINT  D  (11.5)
of capital  VF 
and value rWACC  .15   1  .4  .6   .114
are $1,140
VF, WACC, 0   $10, 000
.114
Using the M&M Formulas for
a No-Growth Perpetuity
 We can use the
APV method to $1,140 .4  .1 .6  $10, 000
measure the same VF, APV, 0  
value
.15 .1
 VD = .6 x $10,000
 But most  $7, 600  $2, 400
companies are
growing and do
not have perpetual  $10, 000 VITS = 24% of VF
debt

Using the M&M Formulas
for a Constant-Growth Perpetuity
 Assume a 5% constant-growth perpetuity
 How do the costs of capital and value change?
$1,140 $1,140 .4  .1 .6  $10, 000

VF, WACC, 0   $10,000 VF, APV, 0  
.15 .1
.114
versus
 $7, 600  $2, 400  $10, 000
$1,140 versus
VF, WACC, 0   $17,812.5
.114  .05 $1,140 .4  .1 .6  $17,812.5
VF, APV, 0  
.15  .05 .1  .05
 $11, 400  $8,550  $19,950

 Assume a $1,140
VF, WACC, 0   $10,000
5% .114
constant- versus
$1,140
growth VF, WACC, 0   $17,812.5
.114  .05
perpetuity
$1,140 .4  .1 .6  $10, 000
 How do the VF, APV, 0 
.15

.1
costs of  $7, 600  $2, 400  $10, 000
versus +356%
capital and +50% $1,140 .4  .1 .6  $17,812.5
VF, APV, 0  
value .15  .05 .1  .05
V = 43%
 $11, 400  $8,550  $19,950 ITS
change? of VF
 Why don’t the WACC and APV DCF methods
yield the same answer?
 The problem is that we made inconsistent
assumptions
 The levering equation assumed the debt was constant
 We then applied the resulting cost of capital to a situation
where the debt was growing
 If you really believe it is appropriate to value interest tax
shields at the cost of debt in this case (growing firm, constant
D/V) the estimated equity cost of capital is too high)
 This is why the APV cannot replicate the WACC DCF
 Assume a rE = rUA   rUA  rD  
VD
VE
V
+  rUA  rPS   PS
VE
(10.5)
constant- rE  .15   .15  .1  2   .15  .11  .333  .2633

growth
VE VD V
perpetuity rWACC = rE
VF
+ rD  1 - T 
VF
+ rPS PS
VF
(5.6)
but discount rWACC  .2233  .3  .1   1  .4   .6  .11  .1  .126
ITSs at the or
VD
unlevered rWACC = rUA  rD  T 
VF
(11.3)
cost of rWACC  .15  .1 .4  .6  .126
capital $1,140
VF, WACC, 0   $15, 000
.126  .05
 We can use the
$1,140 .4  .1 .6  $15, 000
APV method to VF, APV, 0  
.15  .05 .15  .05
measure the same
value  $11, 400  $3, 600
 VD =
.6 x $15,000  $15, 000 VITS = 24% of VF
 Example illustrates
the incorrect use of
M&M with taxes
Error from Assuming βD = βPS = 0
 A common assumption practitioners make when levering
and unlevering betas is to assume that the debt—and,
indeed, all non-common equity securities (debt,
preferred stock, stock options, warrants, …)—have a
beta equal to zero
 The direct implication is that cost of capital for all non-
common equity securities is the risk-free rate, which is
clearly incorrect
 The effect of this assumption (assuming they measure
the unlevered cost of capital correctly) is to overstate the
equity cost of capital and thus, the weighted average cost
of capital
 For example, the unlevering formula assuming r ITS
= rUA becomes
 Assuming non-equity betas are zero decreases the

unlevered cost of capital
 Recall the Comp Co.
Market Data:
Risk-Free Rate 5.0%
Market Risk Premium 7.0%
Income Tax Rate 40.0%
Comparable Company Cash Flow, Capital Structure and Market Data:

Observed Equity Beta 1.667
CAPM Equity Cost of Capital 16.7%
Equity to Value 30.0%
Cost of Debt 8.0% Cost of Preferred Stock 9.0%

Debt Beta 0.4286 Preferred Stock Beta 0.5714
Debt to Value 50.0% Preferred to Value 20.0%
Company We Are Valuing (Only Equity Financing):

Free Cash Flow $ 1,200.00
Growth Rate (Constant in Perpetuity) 3.0%
 What is the effect of assuming non-common equity
betas = 0?
Company We Are Valuing (Only Equity Financing):
Unleverd Beta Using Betas for All Securities: Unlevered Beta Assuming Zero Non-Equity Betas:
β UA = β E x VE /VF + βD x VD /VF + β P S x VP S/VF 0.829 β UA = β E / (1 + VD /VE + VP S/VE ) 0.500
Unlevered Cost of Capital 10.80% Unlevered Cost of Capital 8.50%
Value of Unlevered Firm - APV Method $ 15,385 Value of Unlevered Firm - APV Method $ 21,818
Valuation Error 42%
 The levering formula assuming rITS = rUA assuming
zero betas becomes
 This assumption increases the equity cost of capital

and thus, the weighted average cost of capital
 Recall the U Lever It Company
Correct Comparable Company's Unlevered Beta 1.00
Market Data:
Risk-Free Rate 5.0%
Market Risk Premium 7.0%
Income Tax Rate 40.0%
Company We Are Valuing:

Cost of Debt 8.0% Cost of Preferred Stock 9.0%

Debt Beta 0.4286 Preferred Stock Beta 0.5714
Debt to Value 50.0% Preferred to Value 10.0%
 What is the effect of assuming non-common equity
betas = 0?
Using Betas for All Securities: Assuming Zero Non-Equity Betas:
βE = βUA + (βUA - βD ) x VD /VE + (βUA - βP S) x VP S/VE 1.821 β E = β UA x (1 + VD /VE + VP S/VE ) 2.500
Equity Cost of Capital 17.75% Equity Cost of Capital 22.50%
Weighted Average Cost of Capital 10.400% Weighted Average Cost of Capital 12.300%
Value of the Firm - WACC Method $ 16,216.2 Value of the Firm - WACC Method $ 12,903.2
Valuation Error -20.4%
Levering and Unlevering Formulas
when βD = βPS = 0
Ignoring Equity-Linked Securities
 Many practitioners ignore employee stock options, stock
appreciation rights, warrants, and other similar equity-
linked securities when levering and unlevering the cost
of capital and measuring the weighted average cost of
capital
 The magnitude of the effect of ignoring these securities
depends on the proportion of the firm financed with
these securities
 Ignoring these securities can result in downward biased
cost of capital estimates and, as a result, upwardly biased
valuations (see Chapter 12)
 The cost of equity is reduced when these equity-linked
securities are issued and these securities are levered
What We Covered
Key Concepts and Takeaways - 1
 We use unlevering and levering methods to
measure the cost of capital or beta from
comparable companies
 The specific forms of the unlevering and
levering formulas we use for a company depend
on the risk of – or discount rate for – the interest
tax shields for that company, typically r ITS = rUA
or rITS = rD or a combination of the two
 Guiding principles for choosing the discount rate for
ITSs, and the unlevering and levering formulas are
based on the company’s capital structure strategy
 In the long run, it is unlikely that the amount of debt a
company will issue will be independent of the company’s
value
 Consider financial distress
 When valuing companies with modest leverage and no financial
distress costs, do not use highly levered comps
 When valuing companies experiencing financial distress, may be more
appropriate
© Cambridge Business to use more highly
Publishers 2019 112levered comps
 Interest deduction caps (limitations)
 Interest deduction caps can affect the expected amount and riskiness
(discount rate) of interest tax shields
 Any limitation on the deduction of interest that is a function of the
company’s performance has the potential to increase the riskiness of the
tax shield relative to no interest deduction cap
Key Levering Formulas – Takeaways - 4
Key Levering Formulas – Takeaways - 5
Key Concepts and Takeaways – 6
 We can use the CAPM to measure the cost of capital
from beta (and rF and market risk premium) and we can
use the CAPM to measure the implied beta from the
cost of capital for a security (and rF and market risk
premium)
E(R i )  R F
i = (10.9)
 E(R m )  R F 
Key Unlevering Formulas – Takeaways -
7
Key Unlevering Formulas – Takeaways -
8
 Using Comparable Companies to Estimate Beta
 We typically use comparable companies to help estimate the
cost of capital to improve our precision
 Assumes the comparable companies are indeed comparable
 Estimate each comparable company’s costs of debt, preferred,
equity and capital structure and unlevered beta
 Use the distribution of comparable company unlevered betas
to measure the unlevered beta of the company being valued
 Select a point in the distribution based on the relative
characteristics of the comparable companies
 Use precision adjustments
 Do not use Modigliani and Miller’s “with taxes”
approach for growing companies or for
companies with substantial short-term debt
 Do not assume zero betas for debt and preferred
stock (and other securities used to finance the
company) – it can cause valuation errors
 Ignoring equity-linked securities used to finance
the company can cause valuation errors
*** END ***
Chapter 10
Levering and Unlevering the
Cost of Capital and Beta

Chapter 10 PPT - Holthausen &amp; Zmijewski 2019

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Chapter 10

© Cambridge Business Publishers 2019 2 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 3 Corporate Valuation by Holthausen & Zmijewski

 Since the CAPM is a common way to measure

the unlevered beta , βUA, and other security betas

© Cambridge Business Publishers 2019 7 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 8 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 9 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 10 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 11 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 13 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 14 Corporate Valuation by Holthausen & Zmijewski

value of the ITSs is

 If the debt is perpetual and the ITS

© Cambridge Business Publishers 2019 16 Corporate Valuation by Holthausen & Zmijewski

capital, rUA, the value of the  rD,t  VD,t  TINT,t

amount will not change – but rD  VD  TINT

 Which of the two discount rates

© Cambridge Business Publishers 2019 21 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 22 Corporate Valuation by Holthausen & Zmijewski

.1 $1, 200  .4 .1 $6,000  .25  .4

 Key thing to note is that as of time 0, the risk of all the

© Cambridge Business Publishers 2019 24 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 25 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 26 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 27 Corporate Valuation by Holthausen & Zmijewski

 The dollar expected return on the firm’s resources is

 Isolate the equity cost of capital

© Cambridge Business Publishers 2019 29 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 30 Corporate Valuation by Holthausen & Zmijewski

 How does the levering formula change if we

 Issue perpetual debt and discount ITSs at debt cost of

 What if interest is not tax deductible?

© Cambridge Business Publishers 2019 34 Corporate Valuation by Holthausen & Zmijewski

where VITS =( TINT x VD x rD)/rD= TINT x VD

© Cambridge Business Publishers 2019 35 Corporate Valuation by Holthausen & Zmijewski

 This formula is similar to the formula for discounting all ITSs at

rWACC =.1775×.4 + (1  .4)×.08×.5 + .09×.1=.104

© Cambridge Business Publishers 2019 38 Corporate Valuation by Holthausen & Zmijewski

rWACC =.1575 ×.4 + (1  .4)×.08×.5 + .09×.1=.096

© Cambridge Business Publishers 2019 39 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 41 Corporate Valuation by Holthausen & Zmijewski

rWACC =.1775×.4 + (1  0)×.08×.5 + .09×.1=.12

© Cambridge Business Publishers 2019 43 Corporate Valuation by Holthausen & Zmijewski

 If ITSs grow at a constant rate

ITS1 ITS1   1+g  ITS1   1+g  ITS1   1+g 

1+ rD ITS1 ITS1 1+ rUA

© Cambridge Business Publishers 2019 44 Corporate Valuation by Holthausen & Zmijewski

rWACC =.1760×.4 + (1  .4)×.08×.5 + .09×.1=.1034

FCF1 ITS1 (1  rUA ) VF 

© Cambridge Business Publishers 2019 47 Corporate Valuation by Holthausen & Zmijewski

 Substitute the general levering formula for the rE in the

 The resulting formula for the weighted average cost of

 For zero-growth, perpetual debt with rITS = rD

© Cambridge Business Publishers 2019 50 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 51 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 55 Corporate Valuation by Holthausen & Zmijewski

 If we have a company’s cost of capital for any security,

© Cambridge Business Publishers 2019 57 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 58 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 59 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 60 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 61 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 62 Corporate Valuation by Holthausen & Zmijewski

Chapter 10 PPT - Holthausen & Zmijewski 2019

Chapter 10 PPT - Holthausen & Zmijewski 2019