wenetcashagainstdebt.Weassumethatbothdebtandcash
arerisklessandthatthetaxbenefitfromdebtisexactlyoffset
by the tax paid on interest earned on cash.
Itisgenerallynotagoodideatonetdebtifthedebtisvery
risky orif theinterest rate earned oncash is substantially
lower than the interest rate paid on debt. With a net
debt-to-equityratio,thereisonemorepotentialcomplication,
highlightedin theEmbraercalculation.Anyfirmthathasa
cashbalancethatexceedsitsdebtwillhavenegativenetdebt,
andusingthisnegativenetD/Eratiowillyieldanunlevered
betathat exceedsthe leveredbeta. While thismay trouble
some,itmakessensebecausetheunleveredbetareflectsthe
betaofthebusinessinwhich thefirmoperates.Firms that
havevastcashbalancesthatexceedtheirborrowingcanhave
leveredbetasthatarelowerthantheunleveredbetasofthe
businesses in which they operate.
CONCLUSION
Thischapterexplainstheprocessofestimatingdiscountrates
bybreakingdownfinancingintodebtandequitycomponents,
and discusses how best to estimate the costs of each:
- The cost of equity is difficult to estimate, partly
becauseit isan implicitcost and partlybecause it
varies across equity investors. For publicly traded
firms, we estimate it from the perspective of the
marginalinvestorin theequity,whowe assume is
well diversified. This assumption allows us to
consideronlytheriskthatcannotbediversifiedaway
asequityrisk,andtomeasureitwithabeta(inthe
capitalassetpricingmodel)orbetas(inthearbitrage