andcasharethesame.Inthegrossdebtapproach,we
addthecashbalancebacktotheoperatingassetsand
thensubtractthegrossdebt.Inthenetdebtapproach,
we accomplish the same by subtracting the net debt.Thereasonthatthetwoapproacheswillyielddifferentvalues
liesthereforeinthedifferenceinthecostsofcapitalobtained
with the two approaches. To understand why there is the
difference,considerafirmwithavalueforthenoncashassets
of$1.25billionandacashbalanceof$250million.Assume
furtherthatthis firmhas$500millionin debtoutstanding,
withapretaxcostofdebtof5.90percentand$1billionin
marketvalueofequity.Inthegrossdebtapproach,weassume
thatthegross debt-to-capitalratiothat wecompute forthe
firmbydividingthegrossdebt($500million)bythemarket
valueof thefirm($1,500million)isused tofund bothits
operating and cash assets. Thus, we compute the cost of
capital using the gross debt ratio and use it to discount
operating cash flows.
In the net debt ratio approach, we make a different
assumption.Weassumethatcashisfundedwithrisklessdebt
(and no equity). Consequently, the operating assets of the
firmarefundedusingtheremainingdebt($250million)and
alloftheequity.Theresultinglowerdebtratio(250/1,250)
willusuallyresultinaslightlyhighercostofcapitalanda
lowervaluefortheoperatingassetsandequity.Figure10.4
summarizes thedifferent assumptions we make abouthow
assetsarefinancedunderthetwoapproaches.Notethatthe
cost of the debtused to fund debt in both approaches is
assumedtobetherisk-freerate.Inthegrossdebtapproach,
weassumethatequityusedtofunddebtisalsorisk-free(and
has a beta of zero).