Component Capital Invested After-tax Earnings Value Operating Assets 1000 125 Cash 250 10 Firm 1250 135

PE 1250 250 1500 10.00 25.00 11.11

P/BV 1.25 1.00 1.20

Debt = Equity = Cash = Unlevered beta of operating assets = Levered beta Cost of equity Cost of debt Cost of capital Operating Assets Cash Firm Value Debt Equity Value

Gross Debt Approach Net Debt Approach $500.00 $250.00 $991.25 $924.77 $250.00 1.42 1.849762241 13.25% 6.28% 10.07% $1,241.25 $250.00 $1,491.25 $500.00 $991.25 1.42 1.650326352 12.25% 7.80% ! Cost of debt used has to be 10.64% $1,174.77 $0.00 $1,174.77 $250.00 $924.77

Operating Earnings = Cash Earnings = Tax Rate = Riskfree rate = Risk premium = Cost of debt for the firm =

125 10 40% 4.00% 5.00% 5.90%

125 10 40% 4.00% 5.00% 5.90%

Cost of debt used has to be adjusted to reflect assumptions about cash holdings.

The gross and net debt approaches make different assumptions about how the cash in a firm is funded. In the net debt approach, cash is entirely funded with riskfree debt and the operating assets are funded with a of the equity and the remaining debt. In the gross debt approach, cash is funded with the same mix of debt an equity as the operating assets of the firms. The upshot of this is that the cost of debt that we use in the cost of capital for the two approaches has to be ad to reflect these assumptions. In the net debt approach, the debt carried by the operating assets is much riskie the safest asset (cash) is fully funded with debt. In the gross debt approach, the cost of debt will be lower beca cash shelters some of the debt. In neither case, can the stated cost of debt for the entire firm (which includes and operating assets) be used in the cost of capital. When the tax rate is 0% and the costs of debt are adjusted to reflect the different risks (which this spreadshee the two approaches will yield the same value for equity. As the tax rate rises, the two approaches will diverge net debt approach yielding a lower value. This is because the net debt approach assumes that any tax benefit debt used to fund cash is fully offset by the tax that will have to be paid on the interest income from cash.

n a firm is funded. g assets are funded with all the same mix of debt and

o approaches has to be adjusted ing assets is much riskier since of debt will be lower because tire firm (which includes cash

ks (which this spreadsheet does), approaches will diverge with the mes that any tax benefit from the st income from cash.