Cost of Equity Formulas

According to the M&M theory, the formula for unlevering and levering capital is straightforward, but there are variations of the formula adapted to different situations.

Situations can vary based on two parameters:

1. The organization’s target debt-to-equity (D/E) ratio can either be fixed (meaning the debt correlates with the market value of the organization) or variable (the absolute level of debt is fixed, regardless of changes in the organization’s value).
2. The risk of the tax shield can either correspond to the risk of the total assets (meaning the savings correlate with the organization’s total return) or to the risk of the debt (meaning the tax savings correlate with the return on the debt).

Similarly, the formulas change in the case of levering:

Finally, the formulas also change when unlevering or levering beta:

The corresponding Excel file is available here: Excel File

Source:

Valuation, Measuring and Managing the Value of Companies – by McKinsey & Company, T. Koller, M. Goedhart, D. Wessels