Valuing Companies with a Fixed Book-Value Leverage Ratio

Abstract

We develop valuation formulae for a company that maintains a fixed book-value leverage ratio and claim that it is more realistic than to assume, as Miles-Ezzell (1980), a fixed market-value leverage ratio. The value of tax shields depends only on the present value of the net increases of debt. The value of tax shields in a world with no leverage cost is the tax rate times the current debt plus the present value of the net increases of debt. We also show that the appropriate discount rates for the equity cash flows and for the expected value of the equity are different. It is more realistic to assume that a company maintains a fixed book-value leverage ratio than to assume, as Miles-Ezzell (1980) do, that the company maintains a fixed market-value leverage ratio because the amount of debt does not depend on the movements of the stock market, it is easier to follow for non quoted companies, and managers should prefer so because the value of tax shields is more valuable.

Keywords: valuation, company valuation, valuation errors, value of tax shields, present value of the net increases of debt, required return to equity

JEL Classification: G12, G31, G32