CHAPTER 4
Valuing a Leveraged Equity Security
Our goal in this chapter is to develop a method for valuing an equity security where the corporation’s capital structure includes indebtedness. Since most corporations have debt in their capital structures, any operational or research model of the firm must be able to take this debt into account systematically.
We begin with the basic identities of corporation finance, first in the context of an unleveraged firm. These basic identities can be thought of as the generic equivalent of the scientist’s law of conservation of matter and energy. As in the scientific fields, so in the financial fields: We require basic laws of conservation of financial resources.
This section basically recapitulates the findings of Nobel Prize winners Franco Modigliani and Merton Miller in their pathbreaking work from the late 1950s on capital structure and dividend policy. Readers who are familiar with this material are encouraged to skip ahead.
Common stock valuation of a firm with a given market risk starts from this equation:
where
n = number of shares outstanding at the end of current period t
Pt = current value of a share of common stock
Pt + 1 = value of a share of equity one period hence
DPSt + 1 = dividends, if any, to be paid to the existing common shareholders one period hence
yE = nominal cost of common equity (or expected return or discount ...
