Risk-Neutral Valuation: A Gentle Introduction (2)

29 Pages Posted: 3 Dec 2001

See all articles by Joseph Tham

Joseph Tham

Educational Independent Consultant

Date Written: December 2001

Abstract

This teaching note is a continuation of the previous teaching note on risk-neutral valuation. In Section One, we estimate the value of levered equity in a levered company in an M & M world with risk-free debt and without taxes. The structure of the presentation will facilitate the subsequent analysis with taxes. We find the value of the levered firm in two ways. First, we use the replicating portfolio method. Second, we use the risk-neutral approach, which is equivalent to the replicating portfolio method.

In Section Two, we analyze risky debt in a world without taxes. In Section Three, we introduce taxes. However, we continue to assume risk-free debt. The risk of the tax shield is indeterminate. In Section Four, we analyze risky debt in the presence of taxes and derive the relevant expressions for the returns to the equity and debt holders.

Keywords: Risk-neutral valuation, Cost of Capital

JEL Classification: D61, G31, H43

Suggested Citation

Tham, Joseph, Risk-Neutral Valuation: A Gentle Introduction (2) (December 2001). Available at SSRN: https://ssrn.com/abstract=292724 or http://dx.doi.org/10.2139/ssrn.292724

Joseph Tham (Contact Author)

Educational Independent Consultant ( email )

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