Pass Through Valuation
Hull, Robert M.
Washburn University. School of Business
Kaw Valley Bank
We fill in missing gaps in small business valuation by investigating a pass-through owner managed enterprise undergoing a debt-for-equity exchange to determine its maximum gain to leverage (GL), maximum firm value (VL) and optimal debt-equity ratio (ODE). We utilize a GL equation given by the Capital Structure Model (CSM) of Hull (2007). This GL equation keeps the Modigliani and Miller (1963) and Miller (1977) perpetuity framework and non-growth condition for an unlevered firm issuing debt to retire equity. CSM equations for GL are derived by subtracting definitions for unlevered firm value (VU) from definitions for VL. This derivational procedure enables the CSM to incorporate discount rates into the valuation process. Discount rates are dependent on the degree of market risk and the extent of the debt-for-equity transaction. They are critical in demonstrating the maximum GL, maximum VL and ODE from among feasible leverage choices. We show the standard taxation models cannot properly compute GL for pass-throughs. In applying the CSM, we show a pass-through achieves a higher maximum GL, lower maximum VL, and greater ODE when the personal tax rate on equity is greater than the rate on debt. We offer rules for managers of pass-throughs on how much equity to retire with debt. We compare a pass-through with a corporation when all factors but tax rates are the same. We find a lower maximum GL, higher maximum VL, and lower ODE for a pass-through compared to a corporation. Doubling betas do not affect our major conclusions governing a pass-through.