Therearetwofactorscausingtheequityvaluedifference.The
firstisthatweusedthesamecostofdebtusedunderthetwo
approaches forcomputing thecost of capital foroperating
assets. If there is default risk, the cost of debt used for
computingthecostofcapitalshouldbehigherunderthenet
debtapproach thanunder thegross debt approach.To see
why,considerthecostofdebtof5.9pecentusedinthelast
exampleandassumethatthisisthecostofdebtfortheentire
companyon itstotal debtof$500 million.Inthenetdebt
approach,$250millionofthisdebtisusedtofundcashandis
at therisk-free rate. The pretax cost of borrowing on the
remainingdebt(usedtofundoperatingassets)thereforehas
to be much higher:
Inthegrossdebtapproach,onlyathirdofthecashisfunded
withdebt;thisworksoutto$83.33millionattherisklessrate.
The cost of the remaining debt is as follows: