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| Author: | Brick, I. E. Weaver, D. G. |
| Title: | Calculating the cost of capital of an unlevered firm for use in project evaluation |
| Journal: | Review of Quantitative Finance and Accounting
1997 : SEP, VOL. 9:2, p. 111-129 |
| Index terms: | CAPITAL COSTS CAPITAL BUDGETING PROJECT EVALUATION |
| Language: | eng |
| Abstract: | Calculating the cost of capital for use in risk-adjusted discount capital budgeting procedures generally assumes that the level of debt is either a constant or a constant percentage of the value of the project or firm. Firms generally maintain a debt-equity financing mix based upon target book-value debt-to-asset-ratio rather than a market-value based leverage ratio , namely, the debt-to-total-firm-value ratio. This paper shows that if firms do maintain a constant book-value debt-to-asset ratio, then the use of capital budgeting proceduresbased on market value ratios yield substantial errors in estimating the true net present value of the project. The paper presents a methodology to estimate the cost of equity of an unlevered firm whenever the firm fails to maintain a constant market value -based leverage ratio. |
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