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Measuring Return on Equity Correctly

Why current estimation models set allowed ROE too low.

Fortnightly Magazine - August 2005
  1. principle, both capital budgeting and rate regulation could model the pure cost-based part separately. But this is not done in ordinary practice. Treating the weighted-average cost of capital estimated at normal capital structures as flat when debt becomes excessive is an easy, practical approach to recognizing both effects. (We understand that the next edition of Brealey and Myers, op. cit., may recommend this practice, too.)
  2. The rate at which the cost of equity increases is mitigated by increases in the after-tax cost of debt as higher debt ratios force debt to bear an increasing proportion of the firm’s risk.
  3. These precise values depend on the precise cost of capital curves assumed in Figure 3, but the basic conclusion holds for any set of cost of capital curves consistent with the research on the effects of capital structure on the value of the firm.
  4. Companies in financial distress will be beyond the middle range of capital structures. A ready practical procedure to avoid such companies is to exclude from the 
    sample any companies without investment-grade debt.
  5. The after-tax cost of debt is the current yield to maturity times the quantity, one minus the corporate tax rate. The market value of equity is price per common share times the number of outstanding common shares. Unless the company’s embedded interest rates are far from current market values, analysts typically use the book value of debt in such calculations. Preferred stock should be treated like debt, except that its current yield is already after-corporate-tax.

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