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Applicability of the Classic

WACC Concept in Practice


M. A. Mian
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Ignacio Vélez-Pareja

ABSTRACT. A large percentage of companies use the discounted cash


flow (DCF) approach as the primary technique for investment/project
evaluation and the capital budgeting process. This approach requires
forecasting the detailed cash flow of the project under evaluation and
then discounting the resulting cash flow to the present value (Net Pres-
ent Value–NPV) using an appropriate discount rate.
The discount rate commonly used represents the Weighted Average
Cost of Capital (WACC) of the firm. There is no scarcity of literature on
this subject as the concept has been around for the last 50 years or so. Al-
though most analysts believe the concept is simple and very well known,
the irony is that its misinterpretation and misuse prevails. There are
many versions of the WACC equation and each is specific to a certain
cash flow. Therefore, using the classic WACC relationship in all cases
may result in the calculation of an overly optimistic NPV. Depending on
the cash flow pattern, the investment may show a positive NPV at the
classic WACC but it will actually be losing equity.
This paper highlights (a) pitfalls and misuses of the WACC, (b) inter-
dependence between types of cash flow and WACC, (c) assumptions be-
hind the WACC and whether these assumptions are realistic, and
(d) alternative approaches to arrive at the correct net present value
(NPV). Company CEOs, management, analysts, and other investors us-

M. A. Mian, Engineering Specialist at a Saudi Arabian oil company, has over 27


years of international experience in petroleum engineering (E-mail: mohammad.mian@
aramco.com).
Ignacio Vélez-Pareja, Finance Professor at Universidad Tecnologica de Bolivar,
Cartagena, Colombia, has more than 40 years in teaching and management in private
firms (E-mail: nachovelez@gmail.com).
Latin American Business Review, Vol. 8(2) 2007
Available online at http://labr.haworthpress.com
Ó 2007 by The Haworth Press. All rights reserved.
doi:10.1080/10978520802084123 19
20 LATIN AMERICAN BUSINESS REVIEW

ing the WACC for investment decisions need to be fully aware of its pit-
falls and misuses.

RESUMEN. Un gran porcentaje de empresas usan el enfoque del flujo


de caja descontado (DCF–discounted cash flow), como la técnica princi-
pal para evaluar las inversiones/proyectos y el proceso de elaboración
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del presupuesto de capital. Este enfoque exige la proyección detallada


del flujo de caja del proyecto bajo análisis y, a continuación, el redescuento
del flujo de caja resultante al valor actual–Valor Actual Neto (Net Pres-
ent Value–NPV) utilizando una tasa de redescuento apropiada.
La tasa de descuento comúnmente utilizada representa el Costo de
Capital Medio Ponderado (Weighted Average Cost of Capital (WACC)
de la empresa. No falta literatura a este respecto, ya que el concepto
ha existido ya alrededor de 50 años. Aunque la mayoría de los
analistas creen que el mismo es simple y muy conocido, irónicamente,
lo que prevalece es su mala interpretación y uso equivocado. Existen
muchas versiones sobre la ecuación WACC, y cada una se identifica
con un flujo de caja específico. Consecuentemente, el uso de la relación
WACC clásica puede resultar, en todos los casos, en un cálculo de NPV
exageradamente optimista. Dependiendo del tipo de flujo de caja, la
inversión puede mostrar un NPV positivo con un WACC clásico, cuando
en realidad estará perdiendo patrimonio.
Este documento coloca en destaque (a) escollos y mal uso del
WACC, (b) interdependencia entre el tipo de flujo de caja y el
WACC, (c) presunciones por detrás del WACC, y si ellas son realistas, y
(d) mostrar enfoques alternativos para llegar al valor actual neto correcto
(NPV). El CEO de la empresa, su gerencia, analistas y otros inversores
usarán el WACC para tomar decisiones inherentes a la inversión.

RESUMO. Uma grande porcentagem das empresas usa a abordagem do


fluxo de caixa descontado (DCF) como técnica básica de avaliação de
investimentos/projetos e do processo de orçamentação de capital. Essa
abordagem requer que se preveja o fluxo de caixa detalhado do projeto
sob avaliação e, depois, desconte o fluxo de caixa resultante para obter o
valor presente líquido (NPV) usando uma taxa de desconto apropriada.
A taxa de desconto geralmente usada representa o Custo de Capital
Médio Ponderado (WACC–Weighted Average Cost of Capital) da empresa.
A literatura sobre este tema é abundante, já que o conceito existe há uns
50 anos. Embora a maioria dos analistas considere o conceito simples e
bem conhecido, o fato é que erros de interpretação e utilização predominam.
Existem muitas versões da equação do WACC, cada uma específica a
certo fluxo de caixa. Portanto, aplicar a relação WACC clássica a todos
os casos pode resultar em cálculos de NPVs otimistas demais. Dependendo
M. A. Mian and Ignacio VUlez-Pareja 21

do padrão de fluxo de caixa, o investimento pode exibir um NPV positivo


no WACC clássico, quando na verdade estará perdendo patrimônio.
Este artigo realça (a) as armadilhas e usos equivocados do WACC,
(b) as interdependências entre tipo de fluxo de caixa e WACC,
(c) pressupostos por trás do WACC e se esses pressupostos são realistas,
e (d) mostra abordagens alternativas para se chegar ao valor presente líquido
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(NPV) correto. Visa os CEOs das empresas, a gerência, os analistas e utros


investidores que usam o WACC nas decisões de investimentos. doi: 10.1080/
10978520802084123 [Article copies available for a fee from The Haworth Document De-
livery Service: 1-800-HAWORTH. E-mail address: <docdelivery@haworthpress.
com> Website: <http://www.HaworthPress.com> Ó 2007 by The Haworth Press. All
rights reserved.]

KEYWORDS. Cost of capital, cash flows

INTRODUCTION

A large percentage of companies use the discounted cash flow (DCF)


approach as the primary technique for investment/project evaluation
and the capital budgeting process. This approach requires forecasting
the detailed cash flow of the project under evaluation and then discount-
ing the resulting cash flow to the present value (Net Present Value-
NPV) using an appropriate discount rate.
The discount rate commonly used represents the Weighted Average
Cost of Capital (WACC) of the firm. There is no scarcity of literature on
this subject as the concept has been around for the last 50 years or so.
Although most analysts believe the concept is simple and very well
known, the irony is that its misinterpretation and misuse prevails. There
are many versions of the WACC equation and each is specific to a cer-
tain cash flow. Therefore, using the classic WACC relationship in all
cases may result in the calculation of an overly optimistic NPV. De-
pending on the cash flow pattern, the investment may show a positive
NPV at the classic WACC but it will actually be losing equity.
This paper highlights (a) pitfalls and misuses of the WACC, (b) inter-
dependence between types of cash flow and WACC, (c) assumptions
behind the WACC and whether these assumptions are realistic, and
(d) alternative approaches to arrive at the correct net present value
(NPV). Company CEOs, management, analysts, and other investors using
WACC for investment decisions need to be fully aware of its pitfalls and
misuses.
Introduction
A large percentage of companies use the discounted cash flow (DCF) approach as the primary
technique of investment/project evaluation and capital budgeting process. This approach requires
forecasting detailed cash flow of the project under evaluation and then discounting the resulting
cash flow to the present value (Net Present Value – NPV) using an appropriate discount rate.
The discount rate commonly used represents the Weighted Average Cost of Capital
(WACC) of the firm. There is no scarcity of literature on this subject as the concept has been
around for the last 50 years or so. Although most analysts believe the concept is simple and very
well known, the irony is that its misinterpretation and misuse prevails. There are many versions
of the WACC equation and each is specific to a certain cash flow. Therefore, using the classic
WACC relationship in all cases may result in calculation of overly optimistic NPV. Depending
on the cash flow pattern, the investment may show positive NPV at the classic WACC but it will
actually be loosing on equity.
This paper highlights the (a) pitfalls and misuse of the WACC, (b) interdependence
between type of cash flow and WACC, (c) assumptions behind the WACC and whether these
assumptions are realistic, and (d) shows alternative approaches to arrive at the correct net present
value (NPV). The company CEOs, management, analysts, and other investors using WACC for
investment decisions need to be fully aware of its pitfalls and misuse.

A Review
The interactions between the market value of cash flows and the discount rate (usually the
WACC) to calculate the levered value is a well known problem. (See Myers, 1974). It is
mentioned in almost all textbooks in corporate finance. However, the typical solution offered by
most authors is to assume a constant discount rate which implies a constant leverage D%, and
hence assume that the constant leverage correspond to an optimal capital structure. On the other
hand, most authors use the definition of the Ke, the cost of levered equity for perpetuities even if
the planning horizon is finite. Among these authors we find the work of Wood and Leitch W&L
2004. Vélez-Pareja and Tham, 2005 debate this paper.

Vélez-Pareja and Tham (2000), Tham and Velez–Pareja, 2002, Vélez-Pareja and Burbano
2005, Tham and Velez–Pareja, 2004b, Velez-Pareja and Tham, 2005, have shown and proposed
a very simple manner to tackle the issue of circularity. Mohanti, 2003, proposes an iterative
method to solve the issue. Wood and Leitch 2004, (W&L) propose an iterative and approximate
method to solve this circularity.
When we review the literature on this subject we find that either the authors elude the
problem of matching the results using different methods, or use perpetuities (that is a form to
elude the problem), or use very simple example (one period), or simply they say that differences
are not relevant. Taggart 1991, Vélez-Pareja and Tham (2000), Tham, and Velez–Pareja, 2002,
Applicability of the Classic WACC Concept in Practice

Vélez-Pareja and Burbano 2005 and Tham, Velez–Pareja, 2004a and 2004b, have derived
independently the expression for Ke when there are finite cash flows.
In the best reputed textbook in corporate finance, (Brealy, Myers and Allen (BMA) 2006,
8th edition) referring to an example with finite cash flows where APV and FCF methods do not
match (BMA, 2006, page 523):
“… If the debt levels are taken as fixed, then the tax shields should be discounted
back at the 6 percent borrowing rate.
[…] The increase [in value] can be traced to the higher early debt levels and to the
assumption that the debt levels and interest tax shields are relatively safe.” (There is a
foot note that says: “But will Rio really support debt shown […]? If not, then the debt
must be partially supported by Sangria’s [the firm that would buy Rio] other assets,
and only part of the 5 millions in PV(interest tax shields) can be attributed to Rio
itself”.)
On page 524, they say: “Now a difference of 1.4 million is not a big deal considering
all the lurking risks and pitfalls in forecasting Rio’s free cash flows. But you can see
the advantage of the flexibility APV provides. The APV spreadsheet allows you to
explore the implications of different financing strategies without looking into a fixed
debt ratio or having to calculate a new WACC for every scenario.
APV is particularly useful when debt for a project or business is tied to book value or
has to be repaid on fixed schedule”.
In Vélez-Pareja and Tham, 2006, they show that the two methods give identical results
using the same example proposed by BMA.
Ross, Westerfield and Jaffre (RWJ), 1999, page 441, say, referring to three methods to
calculate the levered value of a firm for perpetuity:
“The net present value […] is exactly the same under each of the three methods
[PV(FCF at WACC, PV(ECF at Ke) + debt and Adjusted present value, APV].
However, one method usually provides an easier computation than another, and, in
many cases, one or more of the methods are virtually impossible computationally.
[…]
[…] if the debt-to-value ratio remains constant over the life of the project, both rs and
rWACC will remain constant as well. However, if the debt-to-value ratio varies from
year to year, both rs and rWACC vary from year to year as well. Using the FTE [ECF]
or the WACC approach when the denominator changes every year is computationally
quite complex, and when computations become complex, the error rate rises. Thus,
both the FTE and WACC approaches present difficulties when the debt-to-value ratio
changes over time.”
Copeland, Koller and Murrin, 2000, (page 148) say “You may have noted that the
enterprise value of operations does not exactly match that given by the APV approach. The
difference is about 2 percent. The enterprise DCF model assumes that the capital structure (the

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Applicability of the Classic WACC Concept in Practice

ratio of debt to debt plus equity in market values) and WACC would be constant every period.
Actually the capital structure changes every year.”
Benninga and Sarig, 1997, (page 418) when the values of equity under different methods
do not match, say: “As you can see, the results of the two valuations are very close. The
differences are caused by the fact that we have used cost of capital formulas for no-growth,
infinitely lived models to do the valuation job in our pro-forma framework, in which cash flows
are projected to grow.”
We have mentioned the most popular books on valuation and we can see that either they
do not solve the problem of matching the values under different methods or simply they elude it.
In this paper we show how to solve this and show that the matching of values calculated under
different methods is possible and very easy to do.

Defining Weighted-Average Cost of Capital


The weighted-average cost of capital (WACC), as the name implies, is the weighted average of
the firm’s overall capital structure, i.e., its cost of equity (KE) and its cost of debt (KD). For the
purpose of this paper it is assumed that the firm’s cost of equity and cost of debt have been
already calculated using the acceptable financial techniques, such as the Capital Asset Pricing
Model (CAPM). Some analysts misinterpret the WACC as synonym of CAPM. This is not
correct, they are not synonyms. The WACC is just an algebraic manipulation to combine the KE
and KD into their respective proportion, reflecting the capital structure of the firm. The most
classic forms of the WACC are shown below.
After-tax WACC

WACC AT = WE × K E + WD × K D (1 − Tc ) (1)

Before-tax WACC

WACC BT = WE × K E + WD × K D (2)

Where WE is the weight of equity related to the value of the firm, KE is the levered cost of
equity, WD is the leverage related to the value of the firm, KD is the cost of debt and Tc is the
corporate tax rate.
Under certain assumptions we can call the WACCBT as the WACC for the Capital Cash
Flow (CCF). The two equations above define the WACC in terms of the variables shown in
Table 1. In that table we show the numbers for an illustrative example.

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Applicability of the Classic WACC Concept in Practice

Table 1. Typical Variables used in the WACC Calculation

Risk Free Rate of Return KF 5.45%


Expected Market Risk Premium K mp 6.40%
Systematic Market Risk, Levered Beta (from CAPM) βL 0.71
Unlevered Beta, β UL = β L (1 + WD ) β UL 0.57
Credit Risk Premium βD 0.7%
Corporate Tax Rate Tc 35%
Debt-to-Value Ratio WD 25%
Equity-to-Value Ratio WE 75%
Cost of Levered Equity, K L E = K F + K mp × β L KLE 10.0%
Cost of Unlevered Equity, K ULE = K F + β UL × K mp K UL E 9.10%
Cost of Debt, K D = K F + β D KD 6.15%

The classic WACC (WACCAT) equation is basically composed of three parts. The first part
(WE x KE) represents the equity portion of the cash flow, the second part (WD x KD) represents the
debt portion of the cash flow, and the third part (1 – Tc) in the second term of Equation (1)
adjusts the interest payment for the tax benefit due to the tax-deductible interest payments. The
WACCAT and WACCBT for the data in Table 1 are calculated as shown below.

WACC AT = 0.75 × 10% + 0.25 × 6.15% × (1 − 0.35) = 8.5%

WACC BT = 0.75 × 10% + 0.25 × 6.15% = 9.04%

The WACC represents the expected return on a portfolio of all the company’s securities,
i.e. equity and debt. This rate is applied to project cash flows — cash flows excluding the cash
outflows due to financing (i.e., interest payment, principal payment or the tax benefit created due
to the tax deductible interest payments when derived indirectly). The side effects of the project
financing are instead bundled in the WACC.

Defining Cash Flows


The reason for defining various cash flow streams is that there is interrelationship between the
type of cash flow and the corresponding WACC. The difference between the various cash flows
is solely in their treatment of the value of leverage. This is a very crucial point, which is always
overlooked. This point has significant implications with respect to the definitions of the cost of
capital, cost of equity, and cost of debt. Ignoring this point leads to considerable confusion and
potential errors in applying the discounted cash flow concept. In fact, this is where most analysts

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Applicability of the Classic WACC Concept in Practice

violate the assumptions on which the discounted cash flow concept is based and thus start
misusing it.
The most straightforward and intuitive way to see the differences is to numerically specify a
particular cash flow, with its respective cost of capital, and then compare the resulting
profitability yardsticks from the various cash flow streams. Some of the most commonly
encountered cash flows in text books and journals are, according to Ruback, 1995:
FCF (Free Cash Flow) — as shown in Table 2, FCF assumes a hypothetical all equity capital
structure, i.e., total net cash flow—no disbursement of interest and principal payments to
debt holders. The interest and principal payments and tax benefits due to deductible
interest payments are incorporated in the discount rate (after-tax weighted average cost of
capital, WACCAT) rather than the cash flow. It is the available funds for distribution and
actually distributed among the portfolio of all the company’s securities.

Table 2. Free Cash Flow (FCF)


Years 0 1 2 3 4 5
Gross Income 1,000 950 950 900 800
Operating Expenses (100) (95) (95) (90) (80)
Interest Expenses
Depreciation (500) (500) (500) (500) (500)
Taxable Income 400 355 355 310 220
Income Tax @ 35% (140) (124) (124) (109) (77)
Net Income 260 231 231 202 143
Initial Investment (2,500)
Loan Proceeds
Principal Payments
Depreciation 500 500 500 500 500
Free Cash Flow (FCF) (2,500) 760 731 731 701 643

ECF (Equity Cash Flow) — includes debt payments (principal and interest) to debt holders. The
resulting cash flow, as shown in Table 3, is net to the Equity shareholders. This is the
classic cash flow and portrays a true image of the cash balance at the company’s treasury.
Since the debt cash flows are included in the cash flow, the cost of equity (KE) rather than
the WACCAT is used for discounting. Or the other way around, it is the cash flow left from
the FCF after the debt holders are paid out.

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Applicability of the Classic WACC Concept in Practice

Table 3. Equity Cash Flow (ECF)


Years 0 1 2 3 4 5
Gross Income 1,000 950 950 900 800
Operating Expenses (100) (95) (95) (90) (80)
Interest Expenses (43) (35) (27) (18) (9)
Depreciation (500) (500) (500) (500) (500)
Taxable Income 357 320 328 292 211
Income Tax @ 35% (125) (112) (115) (102) (74)
Net Income
Initial Investment (2,500)
Loan Proceeds 707
Principal Payments (130) (134) (145) (150) (148)
Depreciation 500 500 500 500 500
Equity Cash Flow (ECF) (1,793) 602 574 568 540 489

CFD (Cash Flow to Debt holders) — Loan proceeds and Interest and principal payments, to the
debt holders, on the outstanding debt.
CCF (Capital Cash Flow) — cash flow is available to both equity and debt holders. As shown in
Table 4, it includes only the tax benefit of tax deductible interest. Since the tax benefit is
included in the cash flow, the before-tax weighted average cost of capital (WACCBT) is
used for discounting. Or the other way around, it is what the portfolio of all the company’s
securities receives. In other words, it is the sum of the CFD and the ECF.
The differences in the three cash flows, using Table 2 as the Base Case, are highlighted in Tables
3 and 4. All cash flows will incorporate adjustments to transform the accounting recognition of
receipts and disbursements into cash flow definitions. The adjustments include operating
expenditure, capital expenditure, depreciation, depletion if applicable, amortization, changes in
working capital, and any other cash or non-cash expenses. The only difference is in the treatment
of CFD. The non-cash expenses such as depreciation, amortization, depletion, and loss carry
forward etc. are subtracted from the taxable income and then added back to the Income after Tax.
The capital cost and changes in working capital are subtracted from the Income after Tax only.

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Applicability of the Classic WACC Concept in Practice

Table 4. Capital Cash Flow (CCF)


Years 0 1 2 3 4 5
Gross Income 1,000 950 950 900 800
Operating Expenses (100) (95) (95) (90) (80)
Interest Expenses
Depreciation (500) (500) (500) (500) (500)
Taxable Income 400 355 355 310 220
Income Tax @ 35% (140) (124) (124) (109) (77)
Net Income 260 231 231 202 143
Interest Tax Savings (ITS) 15 12 10 6 3
Initial Investment (2,500)
Loan Proceeds
Principal Payments
Depreciation 500 500 500 500 500
Capital Cash Flow (CCF) (2,500) 775 743 741 708 646

Table 5 summarizes the type of cash flow and the corresponding discount rate to be used.

Table 5. Type of Cash Flow and the Corresponding Discount Rate

Cash Flow Discount Rate To Calculate


CFD Cost of Debt, Kd Market Value of Debt
ECF Cost of Levered Equity, KLE Market Value of Equity
FCF WACCFCF Levered Market Value of Firm
FCF Cost of Unlevered Equity, KULE Unlevered Market Value of Firm
TS Appropriate Discount Rate for TS, Ψ Market Value of the TS
CCF Appropriate Discount Rate for CCF Levered Market Value of Firm

Calculating Profitability Indicators


Remember that the definition of the weighted average cost of capital depends on the definition of
the cash flow stream. Therefore, the correct execution of the concept of WACC becomes critical.
For example, using the definition of cash flow from one approach and the cost of capital
from an alternative approach will not give correct value of the project under evaluation. Many
experienced analysts have committed these mistakes so the matter is not trivial.

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Applicability of the Classic WACC Concept in Practice

The NPV for all the three cash flows in Tables 2 to 4 calculates to $327 provided the right
combination of cash flows and discount rate is used and all the assumptions are met. The right
combination is, of course, discounting the FCF by WACCAT, the ECF by KLE, and the CCF by
WACCBT. Using the WACCAT with ECF and CCF will give NPV’s of $408 and $366,
respectively. These NPV’s are 25% and 12% higher than the correct NPV of $327.
However, this has solved only one problem, i.e. the NPV calculation. What about the other
profitability indicators? Does IRR of the FCF in Table 2 recognize that the equity is leveraged?
The answer is no, not at all. Similarly, all other profitability indicators will be different. The FCF
is equal to the after-tax cash flow of an otherwise identical project with no debt. The IRR reflects
the return on equity; it has to be calculated with the ECF.

Assumptions of the WACC


Beside the interrelationship between the cash flows and WACC, the approach is based on the
following assumptions (see Tham and Vélez-Pareja, 2004, Vélez-Pareja and Tham 2000 and
Vélez-Pareja and Burbano, 2005).
1. The D/V ratio is based on the market value of the investment and not the book value. The
market value of equity and the market value of debt refer to the equity and debt
proportion of the market value (V) of the firm, respectively, so that WE + WD = 100%.
The market value is the discounted value (discounted at the WACCAT) of the FCF.
Therefore, V is not the book value, the amount invested, or the project cost as it is most
commonly interpreted. This is a very crucial assumption of the WACC concept. The
market value of debt and the corresponding interest and principal payments (CFD) for the
cash flow in Table 3 are calculated as shown in Table 6.
Table 6. Cash Flow to Debt Holders (CFD) – Constant Debt-to-Value Case
0 1 2 3 4 5
FCF from Table 2 760 731 731 702 643
PV of FCF at WACCAT = 8.5%, V 2,827 2,307 1,773 1,193 593
Market Value of Debt, WD 25% 25% 25% 25% 25%
Loan Proceeds/Outstanding Loan, Ln = WD x V 707 577 443 298 148
Principal Payment, (Pp)n = L(n-1) – Ln 130 134 145 150 148
Interest Payment, (Ip)n = L(n-1) x KD 43 35 27 18 9
Interest Tax Savings, (ITS)n = (Ip)n x Tc 15 12 10 6 3

The constant D/V ratio does not fit well with observed practice and/or may be difficult to
maintain. Firms more typically manage issue amounts and repayment schedules, and
would find it very difficult to maintain a constant debt ratio in a world of changing equity
values (see Vélez-Pareja and Tham 2005 and Tham and Vélez-Pareja, 2005.

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Applicability of the Classic WACC Concept in Practice

If the constant D/V ratio assumption is violated, all three discount factors will give
different NPVs even if the right combination of cash flow and discount factor is used.
2. The corporate tax rate in Equations (1) and (2) is constant throughout the life of the
investment, i.e. no tax holidays or sliding scale taxes.
3. The term K D (1 − Tc ) in Equation (1) implies that the taxes are paid the same year as they
are accrued.
4. The term K D (1 − Tc ) in Equation (1) also implies that interest will be paid every year
throughout the life of the project.
5. Assumes that the tax shields are always realized in the year in which they occur. This
means that earnings before interest and taxes are greater than or equal to the expected
interest charges and that tax is paid the same year as accrued.
6. Those equations assume that the only source of tax shields is the interest payments.
7. Item 5 above also implies that there are no losses carried forward.
8. The capital cash flow must equal the sum of equity cash flow and cash flow to debt
holders, i.e., CCF = CFD + ECF as shown in Table 7.
9. The Interest tax savings must equal the capital cash flow minus the free cash flow, i.e.,
ITS = CCF – FCF as shown in Table 7.

Table 7. Match Between CCF, CFD and ECF (Proof of Assumptions 7 & 8)
0 1 2 3 4 5
Loan Proceeds 707
Principal Payments (130) (134) (145) (150) (148)
Interest Expenses (43) (35) (27) (18) (9)
Equals – CFD (707) 173 169 172 168 157
Plus – ECF (1,793) 602 574 568 540 489
Equals – CCF (2,500) 775 743 741 708 646
Matches CCF from Table 4 (2,500) 775 743 741 708 646
Less – FCF from Table 2 2,500 (760) (731) (731) (702) (643)
Equals – ITS 0 15 12 10 6 3
Matches ITS from Table 4 0 15 12 10 6 3
Textbook versus Real Investments
The above discussion dealt with textbook cases of the classic WACC concept. However, in
practice the execution of this concept becomes even more complicated and restricted. Over the
years, since inception of this concept, the textbooks and literature have conveniently avoided its
use and limitations in practice. Most conventional investment/ project evaluations may involve:

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Applicability of the Classic WACC Concept in Practice

• Two to four years of construction period in which capital is spent and there is no
revenue.
• Interest accumulates on borrowed money during this construction period.
• Tax holidays and/or variable tax rates.
• Debt repayment schedule less than the total evaluation period of the project, i.e. the
debt-to-value ratio is not constant.
• Conventional debt repayment schedule based on book values rather than the market
values. When we set D%=D/V constant we have to CHANGE debt (up or down) based
on market value in order to maintain D/V constant. The other way around, if we do not
do that, then D/V is not constant.
Tables 8 to 10 show a classic (real life) project cash flows. Table 8 shows FCF of a 10-year
project with three years of construction period. Table 9 shows CCF of the data in Table 8 with
the addition of the interest tax savings. Table 10 shows ECF of the data in Table 8 with the
addition of a 5-year debt repayment schedule. Conventional, not based on market value of
project, debt repayment schedule is used to payback the debt in five years. Interest is applied to
the debt during the construction period.
Table 8. Free Cash Flow (FCF)

1 2 3 4 5 6 7 8 9 10 11 12 13
Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Interest Payment

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 547.0 502.0 502.0 457.0 367.0 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (191.5) (175.7) (175.7) (160.0) (128.5) (112.7) (97.0) (81.2) (65.5) (49.7)

Equal Income after tax - - - 355.6 326.3 326.3 297.1 238.6 209.3 180.1 150.8 121.6 92.3

Less Capital Cost (CAPEX) (706.0) (1,412.0) (1,412.0)

Plus Loan Proceeds

Less Principal Payments

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Equal Free Cash Flow, FCFn (706.0) (1,412.0) (1,412.0) 708.6 679.3 679.3 650.1 591.6 562.3 533.1 503.8 474.6 445.3

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Applicability of the Classic WACC Concept in Practice

Table 9. Capital Cash Flow (CCF)


1 2 3 4 5 6 7 8 9 10 11 12 13
Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Interest Payment - - - - - - - - - -

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 547.0 502.0 502.0 457.0 367.0 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (191.5) (175.7) (175.7) (160.0) (128.5) (112.7) (97.0) (81.2) (65.5) (49.7)

Equal Interest Tax Shield 19.9 16.4 12.7 8.7 4.5 - - - - -

Less Income after tax - - - 375.5 342.7 339.0 305.7 243.0 209.3 180.1 150.8 121.6 92.3

Plus Capital Cost (CAPEX) (706.0) (1,412.0) (1,412.0) - - - - - - - - - -

Less Loan Proceeds - - - - - - - - - -

Plus Principal Payments - - - - - - - - - -

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Capital Cash Flow, CCFn (706.0) (1,412.0) (1,412.0) 728.5 695.7 692.0 658.7 596.0 562.3 533.1 503.8 474.6 445.3

Table 10. Equity Cash Flow (ECF)


1 2 3 4 5 6 7 8 9 10 11 12 13
Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Interest Payment (57.0) (46.9) (36.2) (24.9) (12.8) - - - - -

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 490.0 455.1 465.8 432.1 354.2 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (171.5) (159.3) (163.0) (151.3) (124.0) (112.7) (97.0) (81.2) (65.5) (49.7)

Equal Income after tax - - - 318.5 295.8 302.8 280.9 230.2 209.3 180.1 150.8 121.6 92.3

Less Capital Cost (CAPEX) (706.0) (1,412.0) (1,412.0) - - - - - - - - - -

Plus Loan Proceeds, 25% of CAPEX 176.5 353.0 353.0 - - - - - - - - - -

Less Principal Payments (163.9) (174.0) (184.7) (196.0) (208.1) - - - - -

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Equal Equity Cash Flow, ECFn (529.5) (1,059.0) (1,059.0) 507.6 474.9 471.1 437.9 375.2 562.3 533.1 503.8 474.6 445.3

The NPVs of the cash flows in Tables 8 to 10 are shown in Table 11. The difference in the
NPVs is worth noting. The NPV based on the WACCAT or WACCBT from (1) and (2) and KLE
from Table 1 is 156% more than the NPV of the ECF. This clearly shows that violating the
assumptions on which the methodology is based (i.e. market value of debt and the constant debt-
to-value ratio) could be catastrophic. The magnitude of the difference depends on the cash flow
pattern. In some cases the difference may not be as severe as shown in this example. Such a
difference can easily lead to selecting an investment that will show a positive NPV but the
investment will actually loose on equity.

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Applicability of the Classic WACC Concept in Practice

Table 11. NPV of Cash Flows in Tables 8 to 10


% Different % Different
Type of Cash Flow NPV
from ECF from APV

Free Cash Flow – FCF at WACCAT $ 142.5 156% 54%


Capital Cash Flow – CCF at WACCBT $ 101.2 82% 10%
Equity Cash Flow – ECF at KLE $ 55.6 0% -39.7%
Adjusted Present Value (APV) $ 92.5 0%

The example just presented is dramatic, but subtle versions of the same magnitude are
mundane. The source of difference is mainly due to failure to observe the interdependence of the
individual elements of the WACC with the cash flow itself and failure to meet the assumptions
as described below.
1. The WACCAT equation assumes constant Debt-to-Value ratio of 25%. However, as
shown in Figure 1, this ratio is higher than the 25% in the beginning and it is zero in the
later years of the project. This fact is not recognized by the WACCAT thus exaggerating
the NPV. The issue here is to assume that leverage (and WACC) is constant when it is
not.
2. Figure 2 shows that the actual interest payments have been over the years 2009 to 2013.
However, the WACCAT does not recognize this and keeps on accounting for tax savings
due to interest in the years 2006 to 2008 and then in the years 2014 to 2018.
3. Figure 3 shows that the cost of equity is not constant. However, the WACCAT is based on
the assumption that the cost of equity is 10% throughout the project life.
As shown above, the difference in the NPV from one method to the other is due to the
violation of the assumptions on which the WACC concept is based. These kinds of discrepancies
can be avoided if the relationship between the cash flow items and the discount factor are
ascertained.

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Applicability of the Classic WACC Concept in Practice

Figure 1. Debt-to-Value Ratio of the Cash Flows in Tables 8 to 10.

Figure 2. Actual ITS Applicable to Cash Flows in Tables 8 to 10.

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Applicability of the Classic WACC Concept in Practice

Figure 3. Actual Cost of Equity Applicable to Cash Flows in Tables 8 to 10.


Table 12 shows the use of four different methods, each acknowledging the cash flow
structure and corresponding discount rate, to arrive at the NPV. It is worth noting that all four
methods calculate identical NPV of $92.5. The methods used to arrive at the NPV’s in Table 12
are described in the following pages.
1. The PV(FCF) is calculated using Equation (3). The calculation of NPV in this way
involves iterative solution (circularity in MS Excel™). To solve circularity in MS
Excel™, go to Tools  Options  Calculations  tick Iteration.

FCFt +1 + PV (FCF )t +1
PV (FCF )t = (3)
1 + WACCt +1

where1
ITS t
WACCt = K ULE −
PV (FCF )t −1

1
Taggart 1991, presented this expression for WACC and Vélez-Pareja and Tham (2000), Tham, and Velez–Pareja, 2002, Vélez-
Pareja and Burbano 2005 and Tham, Velez–Pareja, 2004a and 2004b, derived independently the expression when cash flows are
finite.

M. A. Mian & Ignacio Vélez-Pareja Page 16 of 21


Table 12. Alternative Approaches to Calculating NPV
NPV 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Debt Cash Flow, CFD (177) (353) (353) 221 221 221 221 221 - - - - -

Equity Cash Flow, ECF (530) (1,059) (1,059) 508 475 471 438 375 562 533 504 475 445

Capital Cash Flow, CCF = CFD + ECF (706) (1,412) (1,412) 728 696 692 659 596 562 533 504 475 445

Free Cash Flow, FCF (706) (1,412) (1,412) 709 679 679 650 592 562 533 504 475 445

Interest Tax Saving, ITS = CCF - FCF - - - 20 16 13 9 4 - - - - -

WACC = KULE - TS/PV(FCF) 9.10% 9.10% 9.10% 8.59% 8.64% 8.70% 8.79% 8.91% 9.10% 9.10% 9.10% 9.10% 9.10%

PV(FCF) 92.5 807 2,292 3,913 3,540 3,167 2,763 2,356 1,974 1,592 1,203 809 408 -

Outstanding Debt, D 177 540 927 763 589 404 208 0 - - - - -

PV(ECF), V = ECF/KLE 92.5 630 1,752 2,986 2,778 2,578 2,359 2,148 1,974 1,592 1,203 809 408 -

Debt-to-Value Ratio, D/V 28.00% 30.84% 31.03% 27.46% 22.84% 17.13% 9.69% 0.00% 0.00% 0.00% 0.00% 0.00%

KLE = KULE + (KULE - KD) * W D 9.10% 9.93% 10.01% 10.02% 9.91% 9.77% 9.61% 9.39% 9.10% 9.10% 9.10% 9.10% 9.10%

NPV - Capital Cash Flow @ KULE 92.5

Adjusted Present Value, APV 92.5 <== (NPV of FCF + NPV of ITS) @ KULE
Applicability of the Classic WACC Concept in Practice

2. The PV(ECF) is calculated using Equation (4). The calculation of NPV in this way
involves iterative solution (circularity in MS Excel™) by which the discount rate each
year is calculated based on the D/V during that year as shown below.

ECFt +1 + PV (ECF )t +1
PV (ECF )t = (4)
(1 + K LE )t

where

ITS t
WACCt = KULE −
PV ( FCF ) t −1

And

WDt −1
K LEt = K ULE +(K ULE − K D )
WEt −1

Dt −1
(WD )t −1 =
Dt −1 + PV (ECF )t −1

PV (ECF )t −1
(WE )t −1 =
Dt −1 + PV (ECF )t −1

Where

(D )t −1 = Outstanding Debt during year t-1

3. The capital cash flow (CCF) is discounted using the Unlevered cost of equity (KULE =
9.10% from Table 1).
4. The Adjusted Presented Value (APV) is the sum of the NPV of FCF at the Unlevered
cost of equity and the PV of the ITS at the Unlevered cost of equity. The formula for
WACC, KLE and WACC for CCF (equal to KULE) are correct UNDER the assumption
that the discount rate of the ITS is KULE.

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Applicability of the Classic WACC Concept in Practice

Concluding Remarks
The above analyses prove that the only compelling virtue for advocating the use of the classic
WACC equation [as shown in Equation (1)] is that it requires simplified cash flow. This
property, of course, could have been important in the past to users of calculators, interest tables
and/or slide rule. However, due to the tremendous power of spreadsheets like MS Excel™, that
advantage is irrelevant today. Moreover, one has to make sure that the simplification is worth
compromising on the ultimate decision making.
Based on the above analyses, it is recommended to either use the ECF and the cost of equity
(KLE) combination to calculate the NPV’s or use the Adjusted Present value (APV). The ECF is
also the cash flow that, at the end of the day, will be used for budgeting and planning purposes.
The ECF methodology is a good way to obtain a lower bound for the value of the equity. The
NPV based on ECF may, at times, be slightly conservative. This is because the levered cost of
equity (derived from CAPM) is used throughout the project life. Since after the 5-year debt
repayment schedule the un-levered cost of equity will be somewhat less than the levered cost of
equity, the NPV may be slightly conservative. By using the Adjusted Present Value (APV)
method, the NPV for the same investment was calculated to be $92.5.
The bottom line in this issue is to recognize that when properly done, all methods have to
be identical in their results, as was shown in this paper. The wrong approaches give conservative
results in some cases, but the problem is that when the analyst gets different results from
different methods, she will not know which one is the correct one. As a guide, as suggested in
the previous paragraph, if ITS are calculated correctly, the reference point always will be the
APV or the present value of the CCF as the easiest forms to calculate value2.

Bibliographic References
1. Benninga, Simon Z. and Oded H. Sarig, 1997, Corporate Finance. A Valuation
Approach, McGraw-Hill.
2. Brealey, Richard and Stewart C. Myers, 2003, Principles of Corporate Finance, 7th
edition, McGraw Hill-Irwin, New York.
3. Brealey, Richard, Stewart C. Myers and Franklin Allen, 2006, Principles of Corporate
Finance, 8th edition, McGraw Hill-Irwin, New York.
4. Copeland, Thomas and Fred J. Weston, 1988, Financial Theory and Corporate Policy,
3rd Edition, Addison-Wesley.
5. Copeland, Thomas E., Koller, T. y Murrin, J., 2000, Valuation: Measuring and
Managing the Value of Companies, 3rd Edition, John Wiley & Sons, (July 28).

2
The reader has to realize that in the context of this paper we have assumed that ψ, the discount rate for the ITS is
Ku, the cost of unlevered equity.

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Applicability of the Classic WACC Concept in Practice

6. Mohanty, Pitabas, 2003, "A Practical Approach to Solving the Circularity Problem in
Estimating the Cost of Capital". August 13, Social Science Research Network,
http://ssrn.com/abstract=413240
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Implications for Capital Budgeting", Journal of Finance, 29, March, pp 1-25.
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5th edition, Irwin-McGraw-Hill.
9. Ruback, Richard S., 1995, “A Note on Capital Cash Flow Valuation,” Harvard Business
School Case 9-295-069, January 19.
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Corporate and Personal Taxes, Financial Management, Autumn,. pp. 8-20.
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16. Tham, Joseph and Ignacio Vélez-Pareja, 2004c, “Top 9 (Unnecessary and Avoidable)
Mistakes in Cash Flow Valuation,” Working Paper en SSRN, Social Science Research
Network, Jan,
17. Velez-Pareja, Ignacio and Antonio Burbano, 2005, Consistency in Valuation: A Practical
Guide, Social Science Research Network, July 13-15,
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of Capital WACC" (August 7,). Available at Social Science Research Network:
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Leverage: Further Insights" (May 20). Available at Social Science Research Network:
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Applicability of the Classic WACC Concept in Practice

pp. 65-92, January 2. Available at Social Science Research Network:


http://ssrn.com/abstract=653222
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