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Applicability of the Classic

WACC Concept in Practice


M. A. Mian
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
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
(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.
22 LATIN AMERICAN BUSINESS REVIEW

REVIEW

The interactions between the market value of cash flows and the dis-
count rate (usually the WACC) used to calculate the leveraged value is a
well known problem. (See Myers, 1974). It is mentioned in almost all
the textbooks on corporate finance. However, the typical solution of-
fered by most authors is to assume a constant discount rate which im-
plies a constant leverage D%, and hence to assume that the constant
leverage corresponds to an optimal capital structure. On the other hand,
most authors use the definition of the Ke, the cost of leveraged equity
for perpetuities, even if the planning horizon is finite. Among these au-
thors we find the work of Wood and Leitch (W&L, 2004). Vélez-Pareja
and Tham (2005), however, contest the work of Wood and Leitch.
Vélez-Pareja and Tham (2000), Tham and Velez-Pareja (2002),
Vélez-Pareja and Burbano (2005), Tham and Velez-Pareja (2004b), and
Velez-Pareja and Tham (2005) have shown and proposed a very simple
manner for tackling the issue of circularity. Mohanti (2003) proposes an
iterative method to solve the issue. Wood and Leitch (W&L, 2004) pro-
pose an iterative and approximate method to solve circularity.
When we review the literature on this subject we find that either the
authors avoid the problem of matching the results using different meth-
ods, or they use perpetuities (a way to avoid the problem), or they use a
very simple example (one period), or they say simply that differences
are not relevant. Taggart (1991), Vélez-Pareja and Tham (2000), Tham
and Velez-Pareja (2002), Vélez-Pareja and Burbano (2005) and Tham
and Velez-Pareja (2004a and 2004b) have derived independently the
expression for Ke when there are finite cash flows.
In the best reputed textbook on corporate finance (Brealy, Myers and
Allen (BMA) 2006, 8th edition), in referring to an example with finite
cash flows where APV and FCF methods do not match, the authors state
(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]
M. A. Mian and Ignacio VUlez-Pareja 23

other assets, and only part of the 5 millions in PV(interest tax


shields) can be attributed to Rio itself.”)

On page 524, they state: “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 flexi-
bility 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 ev-
ery 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), the authors show that the two
methods give identical results using the same example proposed by
BMA.
Ross, Westerfield and Jaffre (RWJ, 1999, p. 441), referring to three
methods to calculate the leveraged value of a firm for perpetuity, state:

“The net present value [. . .] is exactly the same under each of the
three methods [PV(FCF at WACC, PV(ECF at Ke) + debt and Ad-
justed present value, APV]. However, one method usually pro-
vides 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 ap-
proaches present difficulties when the debt-to-value ratio changes
over time.”

Copeland, Koller and Murrin (2000, p. 148) state: “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 en-
24 LATIN AMERICAN BUSINESS REVIEW

terprise DCF model assumes that the capital structure (the ratio of debt
to debt plus equity in market values) and WACC would be constant ev-
ery period. Actually the capital structure changes every year.”
When the values of equity under different methods do not match,
Benninga (1997 p. 418) states: “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 mod-
els 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 un-
der different methods or they simply avoid it. In this paper, we show
how to actually solve the problem and we show that the matching of val-
ues 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 pa-
per, it is assumed that the firm’s cost of equity and cost of debt have
been already calculated using acceptable financial techniques, such as
the Capital Asset Pricing Model (CAPM). Some analysts misinterpret
the WACC as being synonymous with CAPM. This is not correct; they
are not synonymous. The WACC is simply an algebraic manipulation
used to combine the KE and KD into their respective proportions to re-
flect the capital structure of the firm. The most classic forms of the
WACC are shown below.
After-tax WACC
(1)
Before-tax WACC
(2)
Where
WE is the weight of equity in relation to the value of the firm, KE is
the leveraged cost of equity, WD is the leverage in relation to the value
of the firm, KD is the cost of debt and Tc is the corporate tax rate.
Under certain assumptions, we can label WACCBT as the WACC for
the Capital Cash Flow (CCF). The two equations above define the
M. A. Mian and Ignacio VUlez-Pareja 25

WACC in terms of the variables shown in Table 1. In that table, we pro-


vide the numbers for an illustrative example.
The classic WACC (WACCAT) equation is basically composed of
three parts. The first part (WE ⫻ KE) represents the equity portion of the
cash flow, the second part (WD ⫻ KD) represents the debt portion of the
cash flow, and the third part (1 Tc), given in the second term of Equa-
tion (1), adjusts the interest payment for the tax benefit resulting from
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 resulting from fi-
nancing (i.e., interest payments, principal payments or the tax benefits
created as a result of the tax deductible interest payments when derived
indirectly). The side effects of the project financing are bundled in the
WACC instead.

TABLE 1. Typical Variables Used in the WACC Calculation


26 LATIN AMERICAN BUSINESS REVIEW

DEFINING CASH FLOWS

The reason for defining various cash flow streams is that there is an
interrelationship between the type of cash flow and the corresponding
WACC. The difference between the various cash flows is found 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 po-
tential errors in applying the discounted cash flow concept. In fact, this
is where most analysts 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 hypo-
thetical all equity capital structure, i.e., total net cash flow–no disburse-
ment 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 comprises the funds
available for distribution and funds actually distributed in the portfolio
of all the company’s securities.
ECF (Equity Cash Flow)–includes debt payments (principal and in-
terest) 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 in the company’s account. 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 over from the FCF after the debt holders
are paid off.
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 available to both equity and
debt holders. As shown in Table 4, this 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
M. A. Mian and Ignacio VUlez-Pareja 27

TABLE 2. Free Cash Flow (FCF)

TABLE 3. Equity Cash Flow (ECF)

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 op-
erating expenditures, capital expenditures, 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.
28 LATIN AMERICAN BUSINESS REVIEW

TABLE 4. Capital Cash Flow (CCF)

Table 5 summarizes the types of cash flow and the corresponding dis-
count rate to be used.

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 WACC concept 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 a cor-
rect value for the project under evaluation. Many experienced analysts
have committed such a mistake, so the matter is not trivial.
The NPV for all three cash flows in Tables 2 to 4 calculates as $327,
provided the right combination of cash flows and discount rate has been
used and all the assumptions 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 NPVs of
$408 and $366, respectively. These NPVs are 25% and 12% higher than
the correct NPV of $327.
However, this has solved only one problem, i.e., the NPV calcula-
tion. What about the other profitability indicators? Does IRR of the FCF
in Table 2 recognize that the equity has been leveraged? The answer is
M. A. Mian and Ignacio VUlez-Pareja 29

TABLE 5. Types of Cash Flow and the Corresponding Discount Rate

no, not at all. Similarly, all other profitability indicators will be differ-
ent. 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

Besides 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 respectively to the equity and debt proportion of the market
value (V) of the firm 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.
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)).
30 LATIN AMERICAN BUSINESS REVIEW

TABLE 6. Cash Flow to Debt Holders (CFD)–Constant Debt-to-Value Case

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 through-
out the life of the investment, i.e., no tax holidays or sliding scale taxes.
3. The term KD(1⫺Tc) in Equation (1) implies that taxes are paid the
same year they are accrued.
4. The term KD(1⫺Tc) in Equation (1) also implies that interest will
be paid every year throughout the life of the project.
5. Assuming that the tax shields are always realized in the year in
which they occur means that earnings before interest and taxes are
greater than or equal to the expected interest charges and that the tax is
paid the same year as accrued.
6. These 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.

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 the incep-
M. A. Mian and Ignacio VUlez-Pareja 31

TABLE 7. Match Between CCF, CFD and ECF (Proof of Assumptions 7 and 8)

tion of this concept, the textbooks and literature have conveniently


avoided its use and limitations in practice. Most conventional invest-
ment/ project evaluations may involve:

• A two to four year construction period in which capital is spent and


in which there is no revenue.
• Accumulation of interest on money borrowed during this con-
struction period.
• Tax holidays and/or variable tax rates.
• A debt repayment schedule that is less than the total evaluation pe-
riod of the project, i.e., the debt-to-value ratio is not constant.
• A conventional debt repayment schedule based on book values
rather than market values. When we set D% = D/V as constant, we
have to CHANGE debt (up or down) based on market value in or-
der to maintain D/V as constant; otherwise, if we do not do so, then
D/V is not constant.

Tables 8 to 10 show 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 inter-
est tax savings. Table 10 shows ECF of the data in Table 8 with the addi-
tion of a 5-year debt repayment schedule. A conventional (not based on
market value of project) debt repayment schedule is used to pay off the
debt in five years. Interest is applied to the debt during the construction
period.
32 LATIN AMERICAN BUSINESS REVIEW

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 WACC BT from (1) and (2) and K LE from Table 1 is
156% more than the NPV of the ECF. This clearly shows that vi-
olating 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 lose equity.
The example just presented is dramatic, but subtle versions of the
same magnitude are mundane. The source of difference is mainly

TABLE 8. Free Cash Flow (FCF)

TABLE 9. Capital Cash Flow (CCF)


M. A. Mian and Ignacio VUlez-Pareja 33

TABLE 10. Equity Cash Flow (ECF)

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

due to failure to observe the interdependence of the individual ele-


ments of the WACC with the cash flow itself and failure to meet the
assumptions described as follows:

1. The WACCAT equation assumes a constant Debt-to-Value ratio


of 25%. However, as shown in Figure 1, this ratio is higher than
25% in the beginning and is zero in the later years of the proj-
ect. This fact is not recognized by the WACCAT, thus exagger-
ating 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 are for the
years 2009 to 2013. However, the WACCAT does not recognize
this and keeps on accounting for tax savings due to interest for
the years 2006 to 2008 and then for 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
34 LATIN AMERICAN BUSINESS REVIEW

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

concept is based. These kinds of discrepancies can be avoided if the re-


lationship between the cash flow items and the discount factor are
ascertained.
Table 12 shows the use of four different methods, each ac-
knowledging the cash flow structure and corresponding discount
M. A. Mian and Ignacio VUlez-Pareja 35

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

rate in order to arrive at the NPV. It is worth noting that all four
methods calculate an identical NPV of $92.5. The methods used
to arrive at the NPVs in Table 12 are described as follows.

1. The PV(FCF) is calculated using Equation (3). The calculation of


NPV in this way involves an iterative solution (circularity in MS
Excel(tm)). To solve circularity in MS Excel(tm), go to Tools Æ
Options Æ Calculations Æ click on Iteration.

(3)

2. The PV(ECF) is calculated using Equation (4). The calculation of


NPV in this way involves an iterative solution (circularity in MS
36 LATIN AMERICAN BUSINESS REVIEW

Excel(tm)) by which the discount rate each year is calculated


based on the D/V during that year, as shown.
(4)

3. The capital cash flow (CCF) is discounted using the Unleveraged


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 Unleveraged cost of equity and the PV of the ITS at the
Unleveraged cost of equity. The formula for WACC, KLE and
WACC for CCF (equal to KULE) are correct UNDER the assump-
tion that the discount rate of the ITS is KULE.

CONCLUDING REMARKS
The above analyses prove that the only compelling virtue for advo-
cating the use of the classic WACC equation [as shown in Equation (1)]
is that it requires a simplified cash flow. This property, of course, could
TABLE 12. Alternative Approaches to Calculating NPV

37
38 LATIN AMERICAN BUSINESS REVIEW

have been important in the past to users of calculators, interest tables


and/or slide rules. However, due to the tremendous power of spread-
sheets like MS Excel(tm), that advantage is irrelevant today. Moreover,
one has to make sure that the simplification is worth compromising 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 NPVs,
or to use the Adjusted Present value (APV). The ECF is also the cash
flow that will be used for budgeting and planning purposes at the end
of the day. 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 leveraged cost of
equity (derived from CAPM) is used throughout the project life. Since
after the 5-year debt repayment schedule the un-leveraged cost of eq-
uity will be somewhat less than the leveraged 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 pa-
per. The wrong approaches give conservative results in some cases, but
the problem is that when the analyst gets different results from different
methods, he or 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 will always be the APV or the present
value of the CCF as the easiest forms to calculate value.1

NOTE
1. The reader should realize that in the context of this paper we have assumed that
␺, the discount rate for the ITS, is Ku, the cost of unlevered equity.

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