Alternative formulation for the estimation of cost of funds: sensitivity analysis

Alternative formulation for the estimation of cost of funds: sensitivity analysis

Abstract:

When valuing companies on a discounted cash-flow basis, both academics and practitioners frequently use a formulation based on Modigliani and Miller (1963) and the CAPM (Sharpe, 1964) propositions to estimate the appropriate rate of return to be used. The so-called Beta-levered calculation process can be seen as an example of the former and the Hamada (1969) proposal, which is also frequently used when it can be assumed that Debt is fully guaranteed, is coherent with this approach. We propose an alternative formulation more coherent with Miller’s (1977) propositions, in order to reduce the distortion in the levered Beta calculation when only Corporate Tax effect is taken into account (which is the case of the Hamada equation). In this paper, we show the importance (and sign) of the aforementioned distortion and present a sensitivity analysis related to the most important variables involved in a firm’s under-pricing or overpricing bias: leverage, of both the studied company and the reference company; tax rates in Personal Income Tax (which is related to the extent of the imperfection in the Tax System as a whole); and the expected growth rate for the company.

Keywords: Cost of funds, Levered Beta, Hamada equation, Tax effects, Sensitivity analysis; Discounted cash flows