FORMULAEFORMULAE

Cost of capital and capital structure

 S   B 
k =   k +   k (1 − τ c )
 B + S  e
 B + S  d

E B I T (1 − τ c )
=
V L

k e = ρ + (ρ − k d ) ( 1 − τ )  BS 
c

V L = V U + τc B

E B I T (1 − τ c )
V =
U
ρ

(E B IT − k d B ) (1 − τ )c
S =
k e

 (1 − τ c ) (1 − τ e ) 
V = V + 1 −  B
L U
 ( 1 − τ d ) 
Notation:
k = weighted average cost of capital
ke = cost of equity capital
kd = cost of debt capital
ρ = cost of capital for an unlevered firm
= corporate tax rate
τc
= personal tax rate on equity income
τe
= personal tax rate on debt income
τd

EBIT = earnings before interest and taxes

B = market value of debt
S = market value of equity
VU = value of an unlevered firm
VL = value of a levered firm
Security Market Line (CAPM)
[
E (R i ) = R f + βi E (R m ) − R f ]
= expected return on security i
E (R i )
= risk free rate
= expected return on the market portfolio
R E (Rm ) βi
f

= beta coefficient of security i

Net Present Value

n
C Ft Io
NPV = Σ (1 + k ) t −
1 − h
t=1

h = weighted average floatation cost

k = cost of capital
Io = initial outlay
CFt = cash flow from project in period t
n = life of project (periods)

Gordon Model
Po = D1/(ke - br)

Notation:
Po = time 0 share price
D1 = period 1 dividend
ke = share yield
b = retention rate
r = return on investment

Cost of debt (approximation)

C t + (F − P ) N
k ≈
d
(P + F ) 2

Notation:
 = cost of debt capital
k d

= coupon in period t
C t

= market price
P
= face value
F
= number of periods to maturity
N

Financial leverage and the CAPM

k e = R f [
+ β u E (R m )− R f ] + (β e − βu ) [E (R ) −
m R f ]

[
β e = β u 1 + (1 − τ c ) ( B / S ) ]

Notation:
= cost of equity capital
k e

= risk-free rate
R f

= unlevered (asset) beta

βu

= expected return on the market

E (R m )
= equity beta
βe

= corporate tax rate

τc
Degree of operating, financial and combined leverage

S −V E B IT
D O L = D FL =
S −V − FC E B IT − k d B

S −V
D CL =
S −V − FC − kd B

Notation:
DOL = degree of operating leverage
DFL = degree of financial leverage
DCL = degree of combined leverage
S = sales
V = total variable costs
FC = total fixed costs
EBIT = earnings before interest and taxes
kdB= interest expense