The equation combines the Modigliani–Miller theorem with the capital asset pricing model.
This formula is commonly taught in MBA Corporate Finance and Valuation classes.
The equation is[1] where βL and βU are the levered and unlevered betas, respectively, T the tax rate and
Apart from the effect of the tax rate, which is generally taken as constant, the discrepancy between the two betas can be attributed solely to how the business is financed.
If we substitute the (3) and (4) equation into the (2), then we get these formulas (5), if we suppose that the covariances between the market and the components of equity cash flow are zero (hence β∆IC=βDebtnew=βInterest=0), except the covariance between EBIT and the market: To get the well-known equation, suppose that the value of a firm's assets and the value of firm's equity are equal, if the firm is completely financed by equity and tax rate is zero.