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On the Valuation of a Growing Levered Firm

This paper analyzes the relationships between leverage and value in presence of growth. In the first part we develop a valuation model for the growing firm, adopting the Adjusted Present Value approach (from the equity side), under the assumption of certainty. In the second part, we consider an assets side analysis, equivalent to the APV approach. We find that such analysis cannot be based on the WACC, in the standard formulation, because, in order to obtain directly the equity value, we must adjust k via a factor which turns out to depend not only on l and t, but also on r,g and on k itself. Then we analyse the relationship between reinvestments and growth, via the return on equity link: in order to create value the return on investment (r), reduced by the cost of debt (lk) and the taxation (1-t), should exceed the opportunity cost of capital (k). Since reinvestment has a positive effect on future dividends , but has a negative effect on current dividends which are reduced by the reinvestment of profits, and since firm value depends on all the dividends, the effect of leverage on value is far from being predictable. We demonstrate that three different cases can occur and that an optimum leverage exists: this finding has great policy implications, stating how the creation of value depends on the firm financing decisions.