Distortion in corporate valuation: implications of capital structure changes Jacob Oded Faculty of Management, Tel Aviv University, Tel Aviv, Israel and School of Management, Boston University, Boston, Massachusetts, USA Allen Michel School of Management, Boston University, Boston, Massachusetts, USA, and Steven P. Feinstein Finance Division, Babson College, Wellesley, Massachusetts, USA Abstract Purpose – The traditional discounted cash flows (DCF) valuation procedure used by financial analysts assumes that firms maintain a policy of fixed debt. However, empirical evidence suggests that many firms rebalance their debt. This paper seeks to explore the implication of this discrepancy for valuation of firms that undergo a capital structure change. Design/methodology/approach – The approach taken is both theoretical and empirical. Findings – The authors show how the valuation process should be modified for firms that are expected to rebalance their debt and demonstrate the distortion in value that results if the traditional DCF valuation procedure is used instead. Furthermore, they illustrate the significance of their results using a sample of the largest largest leveraged buyouts of the current decade. Originality/value – To the authors’ knowledge, this is the first investigation into this issue. Keywords Valuations, Finance, Capital structure Paper type Research paper I. Introduction Since the turn of the century, the investment community has witnessed dramatic growth in capital structure changing transactions. This growth has been stimulated by a number of factors including private equity firms and their willingness to structure major leveraged buyouts and firms announcing sizable share repurchase programs[1]. The investment community has been left to assess the impact of such capital structure changes on company value. In particular, this challenge has caused us to revisit one of the more frequently used valuation methodologies, discounted cash flows (DCF). In the standard application of DCF, the expected free cash flows net of corporate taxes are discounted at the weighted average cost of capital (WACC), a rate that accounts for the tax shield from interest payments. Without a capital structure change, finding this discount rate from the financial markets is straightforward. Yet, such a change requires adjusting the discount rate. To make this adjustment, analysts generally use a set of relationships developed by Hamada (1972) almost 40 years ago (Damodaran 2002; Bruner, 2004; Ross et al., 2005). The process involves “unlevering” and then “relevering” the beta, taking into account both the firm’s old and new capital structure. The current issue and full text archive of this journal is available at www.emeraldinsight.com/0307-4358.htm Distortion in corporate valuation 681 Managerial Finance Vol. 37 No. 8, 2011 pp. 681-696 q Emerald Group Publishing Limited 0307-4358 DOI 10.1108/03074351111146175