Finance concepts which assess the risk of a stock by using the leverage (debt to equity ratio) of a firm, in my opinion, are somewhat confusing. For example, in calculating beta for a leveraged firm by using the beta of a unleveraged one, finance books use the book value of equity but for rendering justification for” leveraged effects” (asymmetric response of volatility to positive and negative shock), as debated in econometrics literature, they go for market value of capital, saying when the market stock price decreases, the leverage ratio increases, and so investors expected return of the stock increases to compensate for induced risk.
The market value of equity should be considered to measure leverage as it is a better proxy of financial risk.
The macroeconomic factors are the possible indicators whether funding should be equity or debt. The later is much preferred when economic is upward on contrary during downturn interest rate increases making equity much more attractive and cheaper funding.
Sure but be comparable with same setor benchmarks. And if it is too high you must understand why (eg non recurring project)
Always is market value that has to be considered in levering and unlevering betas and using the weights of D% and E% when calculating WACC. This generates a circularity that is easy to solve with a spreadsheet.
However, if you don't like circularity, use APV or CCF to discount the CFs. I use CCF discounted with Ku the unlevered cost of equity. No circularity. Only has to be adjusted by inflation if it changes from year to year. When using APV and CCF at Ku you need to discount Tax shields with Ku. See this: FCF + TS = CFE + CFD. = CCF.
Formulas fordiscounting depends on the assumption you use to discaount TS and hence calculating VTS, its value.
If interested, look for some of my papers at SSRN.
Sincerely
If you want to measure the real financial risk relating to the stock, one of the most crucial ratios is (Debt@Nominal value / Enterprise Value@market value).
This will show you how likely the firm is to go bankrupt.
The firm' s risk or total risk is the sum of the Business Risk and the Financial Risk. The Financial Risk can be measured by the Debt to Equity ratio. To reflect the true reality of this leverage, the debt equity ratio must be measured by the total market value of the firm Debt divided by the total market value of its equity. From a similar firm with the same asset structure that uses zero debt, we can get the unlevered beta which must be relevered to get the beta of the similar levered firm. This is well known in finance textbooks. The notion of leverage is part of capital structure and has to do with the firm debt policy and optimal capital structure in defining its corporate financial policy. Since the market value of debt and equity changes as the dynamics of the market changes, the financial risk of the firm does changes with market dynamics. Consequently, to accurately reflect risk, market weights must be used in computing the weighted average cost of capital and so market weights must also be used in both the value of debt and the value of equity in computing the debt equity ratio to measure financial leverage.
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