The table presents an example illustrating a widespread and significant error in valuation, related to the assumption of ignoring the beta coefficient of debt or other non-equity sources of financing—in this example, the error amounts to 38%.
Source: Corporate Valuation: Theory, Evidence, and Practice, Mark E. Zmijewski; Robert W. Holthausen
A common practical mistake is ignoring the beta of bonds, preferred stock, and other financial liabilities different from common stock. More precisely, when “unlevering” and “relevering” beta, widely used formulas are applied that rest on the assumption that the beta of all liabilities other than common equity is equal to zero.
Below are the beta un-levering formulas for four different specific situations (see 4 Versions of Unlevering Formulas for details).
Essentially, if we assume that the beta of debt is equal to zero, this implies that the cost of debt for that instrument is equal to the risk-free rate. Such an assumption ultimately results in a higher cost of equity.
Below is the difference between the main formulas, under the assumption that the beta of debt and preferred stock is equal to zero:
Moreover, in such a case, the valuation obtained using the WACC method will not match that obtained using the APV method (because the interest tax shield cannot be negative). It will appear that the value of a levered company is higher than that of an unlevered company, which contradicts the fundamental principles of financial theory.
This is the second example in which an incorrect assumption leads to a serious error, this time in a negative direction.
*Corporate Valuation Theory, Evidence and Practice
Mark E. Zmijewski; Robert W. Holthausen
Second Edition