Calculating The Cost of Capital of an Unlevered Firm For Use in Project Evaluation

The adjusted present value requires an estimate of the cost of equity of an unlevered firm. Traditional approaches for calculating this cost assume that firms maintain a constant market-value percentage of debt when in fact firms typically use a book-value percentage of debt. In this paper, we present an approach to correctly estimate the cost of equity of an unlevered firm whenever the firm fails to maintain a constant market-value-based leverage ratio. We also demonstrate that both the Modigliani and Miller (1963) and Miles and Ezzell (1980) approaches may yield substantial valuation errors when firms determine debt levels based on book-value percentages. In contrast our method makes no errors as long as managers know the marginal tax benefit of debt.