For Finite Cash Flows, What is the Correct Formula for the Return to Levered Equity?

4 Pages Posted: 11 May 2004 Last revised: 31 Mar 2019

See all articles by Joseph Tham

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy; Academy of Public Administration under the President of the Republic of Kazakhstan

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Date Written: May 10, 2004

Abstract

For cash flows in perpetuity without growth, analysts typically use the following formula for the return to levered equity Ke.

Ke = Ku + (Ku ­ Kd)(1 ­ T)D/E (1)

where Ku is the return to unlevered equity, Kd is the cost of debt, T is the tax rate, D is the market value of debt and E is the market value of equity.

What is the corresponding formula for finite cash flows? Is it the same as equation 1? In other words, is equation 1 appropriate for both finite and infinite cash flows? One may be tempted to believe that equation 1 is the general formulation for the return to levered equity and applies to both cash flows in perpetuity and finite cash flows. However, this conclusion is misleading.

In this short note, using simple algebra, we derive the general formulation for the return to levered equity for finite cash flows, and show that equation 1 is not the general formulation for finite cash flows.

Keywords: Present value of the tax shield, formulation for Ke, cost of levered equity, cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value, terminal value, cost of levered equity, cost of unlevered equity, tax savings, growth rate for the free cash flow

JEL Classification: M40, M46, M41, G12, G31, J33

Suggested Citation

Tham, Joseph and Velez-Pareja, Ignacio, For Finite Cash Flows, What is the Correct Formula for the Return to Levered Equity? (May 10, 2004). Available at SSRN: https://ssrn.com/abstract=545122 or http://dx.doi.org/10.2139/ssrn.545122

Joseph Tham (Contact Author)

Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )

Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)

HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx

Academy of Public Administration under the President of the Republic of Kazakhstan ( email )

Abay Street, 33a
Astana
Kazakhstan
+7 8 7172753422 (Phone)

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

Register to save articles to
your library

Register

Paper statistics

Downloads
497
Abstract Views
5,887
rank
56,234
PlumX Metrics