Caveat WACC: Pitfalls in the Use of the Weighted Average Cost of Capital

A comment on Miller R.A., The weighted average cost of capital is not quite right, The Quarterly Review of Economics and Finance (2007), doi:10.1016/j.qref.2006.11.001

Sebastian Lobe* University of Regensburg

Abstract In Discounted Cash Flow valuations, the WACC approach is very popular. Therefore, knowing which limitations the concept inherits is essential. The objective of this paper is thus twofold: First, it is clarified that a constant WACC rate must fail if the implied leverage ratio is time-varying. This seems to be the rationale for defining a nonlinear WACC (NLWACC). However, the NLWACC appears to be rather artificial when allowing for time-varying WACCs. Second, although the NLWACC approach is further amplified in this paper, it must be emphasized that this approach is, even then, applicable only under specific conditions while a time-varying WACC is still able to provide reliable results. In conclusion, the WACC approach is a valid workhorse whose results can be economically interpreted. J.E.L. classification: G11, G3 Keywords: WACC; Cost of Capital; Discount rate; Financial structure; Tax shield

* Center of Finance, Chair of Financial Services, University of Regensburg. Universitätsstraße 31, 93053 Regensburg, Germany. E-mail sebastian.lobe@wiwi.uni-regensburg.de, phone +49 941 943 2727, fax +49 941 943 4979.

Electronic copy available at: http://ssrn.com/abstract=1561188

1. Introduction Methodological issues on valuation have experienced a remarkable renaissance in the financial literature over the last years. Fernandez (2004) initiated a provocative discussion claiming that the value of tax shields is not equal to the present value of tax shields. This claim is indeed provocative as it implies inter alia that the principle of value additivity is not working and that the seminal propositions of Modigliani and Miller are flawed. The subsequent discussion led in several journals revealed that the claim was not well substantiated. For example, Arzac and Glosten (2005) reconsider tax shield valuation looking at a value-based debt policy in the spirit of Miles and Ezzell (1980), and prove the validity of the respective valuation formula. Comments to Fernandez (2004) are given in a comparable vein also by Fieten et al. (2005), Cooper and Nyborg (2006), (2007), and Massari et al. (2008). The advanced textbook by Kruschwitz and Löffler (2006) offers a rigorous and authoritative perspective on Discounted Cash Flow valuation leading to many new insights. Cooper and Nyborg (2008) analyze the case of tax-adjusted discount rates with investor taxes and risky debt. Ruback (2002) advocates the Capital Cash Flows methodology as a simple approach to incorporate the value of the debt tax shield in valuation formulae. His methodology is founded on a value-based debt policy. Booth (2007) makes the case that the Capital Cash Flows and the Adjusted Present Value methodology is not easy to handle in specific valuation scenarios while the weighted average cost of capital (WACC) is a more flexible methodology. For valuing companies or projects, WACC is the dominant Discounted Cash Flow approach in practice. The idea of this long-lived concept is that the total market value (debt and equity) is calculated by discounting the unlevered cash flows with the

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Electronic copy available at: http://ssrn.com/abstract=1561188

Third. Taxes being crucial in this context as shown in the seminal work by Modigliani and Miller (1958). UK. 2007) challenges WACC with a nonlinear WACC (NLWACC). given today’s knowledge. An iterative or recursive procedure is generally not necessary. Also. putting a valid value on the debt tax shield given these estimation problems is not such an easy task. This is not an appealing constellation as it is unknown how much the debt tax shield contributes to the company value. the newly introduced NLWACC is motivated and applied. The merits of WACC and NLWACC are discussed. Therefore. the concept of the NLWACC will be revisited from the perspective of rebalancing the capital structure using WACC before taxes. only a vague idea exists which debt policies companies actually apply.[1] The tax rate t adjusts the return to bondholders downward to reflect the interest tax shield. The remainder of the paper is organized as follows. the NLWACC is generalized to allow for annuities with growth rates g ≠ 0%.weighted returns for shareholders re and bondholders rd. the debt policy does not have to be specified. My concern is to evaluate the validity of his assertion that WACC is not quite right. In other words. applying WACC does not require a commitment to judge how risky debt tax shields are. and Germany supports the WACC’s dominance in practice. the WACC also has its known shortcomings. In section 2. and to examine the potential contribution of NLWACC to the literature. If this inherent mechanism is not acknowledged.[2] Three reasons could support this success: First. the WACC is computationally elegant. (Miller. In section 3. WACC is prone to errors. However. Second. section 4 (1) 2 . However. It implies by definition that a periodic rebalancing of debt takes place to maintain the capital structure set forth in the WACC formula. WACC = w d rd (1 − t) + w e re Recent survey evidence from the US. the input parameters are rather easily estimated from market data.

WACC = w d rd (1 − t) + w e re = 0. 2.105) −8 ≈ $38.06 + 0. and duration N.000. and N = 8. section 5 summarizes shortly the findings and offers an outlook.analyzes the after tax-case. 2) Having performed this exercise Miller (2007) further asks what the equivalent annuity for shareholders CFe and bondholders CFd is? Equivalence here again is 3 . WACC and modified WACC: an example The notion of the modified WACC shall be covered briefly here: 1) Looking at a levered project with given outlays IC0.105 1 − (1.25 ⋅ 0.105 . which break-even unlevered cash flows CF has the project to deliver to be acceptable? Financial acceptance is measured with the net present value NPV. 000 ⋅ 0.86 .173. cost of capital WACC. Finally. To derive a unique solution for this question.12 = 0. This threshold operating cash flow CF belongs to the shareholders and bondholders of the company. IC0 = (2) $200.75 ⋅ 0. an annuity structure (allowing for geometric growth) is imposed:[3] ⎡ (1 + g) N ⎤ ⎢1 − ⎥ CF ⎢ (1 + WACC) N ⎦ ⎥ IC ⋅ (WACC − g) ⎣ ⇔ CF = 0 NPV = 0 = −IC0 + WACC − g (1 + g) N 1− (1 + WACC) N Adopting the numerical example of Miller (2007) which assumes g = 0%. t = 0%. leads to CF = $200.

12 1 − (1 + 0. and CFd = = ≈ $8.43. 000 ⋅ 0.06)−8 ≈ $30.051.247. 000 + ⎣ ⎦ ≈ $0 NPV = −IC0 + r−g 0.06 1 − (1 + 0. interpolating for r yields according to Eq.80) ≠ CF ($38. Miller (2007) suggests discounting this cash flow with a modified version of the WACC dubbing it NLWACC (nonlinear WACC). Obviously.247.247.25 ⋅ $200. 000 ⋅ 0.[5] r −g 1− (1 + g) N (1 + r) N = w e (re − g) 1− (1 + g) N (1 + re ) N + w d (rd − g) 1− (1 + g) N (1 + rd ) N (3) In the numerical example with g = 0%.5% will overestimate the project value in this numerical example.051.23 ⎡1 − (1 + 0.105553 1 − 1.43) + CFd ($8.23) with the textbook WACC of 10. (2): ⎡ (1 + g) N ⎤ ⎥ CF ⎢1 − $38.75 ⋅ 0.86) CF( $38.12 0.25 ⋅ 0. (3): r 1 − (1 + r) −8 = 0.06 + ⇔ r ≈ 0.195. the sum of both annuities differs from the annuity of the sum of both flows: CFe ($30.12) −8 0.105553 4 . This modified WACC is an internal rate of return r which can be expressed as an implicit function when incorporating also the possibility of geometrically growing annuities.105553) −8 ⎤ ⎢ (1 + r) N ⎥ ⎢ ⎥ ⎣ ⎦ = −$200.12−8 1 − 1.80 .achieved by equating the NPV with zero at time T = 0 respectively.75 ⋅ $200. This leads in analogy to Eq.06−8 =0.191236 Discounting with r now leads to a zero-NPV according to Eq.23) 3) Discounting the sum of both annuities ($38.[4] To overcome this misvaluation. (2) to (assuming g = 0%): CFe = w e ⋅ IC0 ⋅ re 1 − (1 + re ) − N w d ⋅ IC0 ⋅ rd 1 − (1 + rd ) − N = 0.173.195.

T (5) 5 . (To be absolutely clear. Also.T ⋅ (1 − t) + w e. the just mentioned Nobel Prize laureate Merton H. I put the NLWACC in perspective using the initial example. Miller is not to be confused with Richard A.). In the following section 3. and VT is the market value at the end of period T. it is necessary to introduce a general return definition. The analysis reveals why a traditional WACC can not work in this scenario. I show how the challenger. WACC with time-varying input parameters can be written down more generally than in Eq. WACC and modified WACC revisited – before taxes First. the weighted average cost of capital equal the unlevered cost of equity.T −1 ⋅ re. the NLWACC. bondholders rd and for both claimholders combined as WACC. VT −1 (4) where DT are inflows/outflows in period T (dividends. and I demonstrate that the NLWACC is a rather narrow concept which is not superior to the WACC. Miller who proposed NLWACC. can be interpreted.T −1 ⋅ rd. it is helpful to remember that in this before tax-setting and under the assumptions set forth by Modigliani and Miller (1958) the capital structure irrelevance theorems hold. The total return R can be defined as a return for shareholders of levered (unlevered) projects re (ru). 3. (1) as follows:[7] WACCT = w d.) This implies that no additional value can be created while dividing the financing funds in a different manner. Secondly. etc.The final deduction of Miller (2007) is that WACC is more or less flawed and that NLWACC is needed. A straightforward and commonly applied definition incurs the total return RT in period T[6] RT = DT + VT − VT −1 . In other words.

forcing the cash flows to shareholders and bondholders to be annuities portrays a rather different scenario (see section 2. Thus. This is demonstrated for the initial example in Panel A of Table 1 showing the expected levels of equity and debt over time given the information at T = 0.T-1 = Vd. and w e.T-1 . Second. The results reveal two remarkable points: First. In fact. It is important to emphasize that the definition of WACC is based on market.T-1 Ve. and not on book value weights. Discounting these cash flows with their respective returns leads to their implied market values. Therefore.T-1 = 1 − w d.T-1 + Vd.One of the constituent characteristics of the WACC concept is that returns to shareholders and bondholders are weighted with their respective market value weights of the prior period: w d. This scenario II is investigated in Table 2. part 2)). 6 . both flows do not conform to an annuity. Based on the calculations in Panel A of Table 1 it is natural to compute the implied cash flows to shareholders and bondholders over the life of the project in Panel B. the cash flow when divided between bondholders and shareholders is sufficient to pay each group its necessary cash flow.T-1 . discounting multi-period cash flows with a time-constant WACC implies ceteris paribus a constant relative capital structure over time. the equity cash flows decrease while the debt cash flows increase over time.

82 38.962.75 38.T (in $) Vd.T-1 – Vd.196.T.173.70 7.936.86 3 30. Vd. VT is the present value of CFT given WACC.173.293.51 89.977.75⋅0.35 119.28 70.86 94.250 8 38.750 0.909. and N = 8.07 38.86 35.810.19 7.T + Ve.T = CFT – CFd.926.173.82 107.12 for CFe. equity market and debt market value over the life cycle of the project T CFT (in $) VT (in $) Ve.886.T.95 0.173.T as in Panel A.250 3 4 38.Table 1: Scenario I (before taxes) Panel A: Total market value.00 0.54 0.750 0.T is the debt market value (wd⋅VT) at date T.000.780.T (in $) CFT (in $) 1 30.67 38.06 for CFd.706.750 0.750 0.719.46 38.700.849.04 9.84 29.879. and wd is the debt weight (debt/total value).00 0.357.86 CFe. Discounting these flows at re = 0.00 150.46 23.000.486.T = Vd.173. The aggregated cash flow to shareholders and bondholders during the period T is CFT = CFe. Panel B: Implied cash flows to shareholders and bondholders over the life cycle of the project T CFe.250 5 38.173.86 7 29. The weights are constant over time.86 65.370.880. CFd.86 6 29.019.76 8.173.40 7.86 5 29.T is the implied cash flow to bondholders during the period T based on Panel A: CFd.173.473.173.173.T-1⋅rd + (Vd.484.577.82 0. 7 .750 0.154.T (in $) CFd.06 + 0.11 8.T (in $) 0 200.452.T and Vd.250 2 38.25⋅0.T leads to the same values of Ve. and rd = 0.86 8.26 0.10 38.86 34.237.16 38.48 25. No taxes t = 0.173.86 38.T is the implied cash flow to shareholders during the period T: CFe.86 163.750 0.57 0.86 142.70 16.26 49.707.80 38.63 45.119. WACC = ru = wd⋅rd + we⋅re = 0.173.T) at date T.86 8 29.T).687.T + CFd.173. Ve.525.689.12 = 0.826. we is the equity weight (equity/total value).06 8.00 - we wd CFT is the aggregated cash flow to shareholders and bondholders during the period T.000.62 0.250 1 38.86 182.750 0.750 0.86 0.250 7 38.17 137.06 122.86 2 30.T.86 4 30.79 7.00 0.79 40.103.546.250 0. VT is the total market value (debt and equity. and Vd.173.T is the equity market value (we⋅VT) at date T.159.803.173.00 50.173.105.250 6 38.636.

43 8.948.714.739.07 33.T wd.T at date T is the present value given CFe.10575 5 0.195.T is the annuity cash flow to shareholders and bondholders.10500 2 0.229 0.T at date T is the present value given CFd.T (in $) Ve.051.T-1⋅rd + we.593. The implied debt market value Vd.000.051.33 21.T) at date T.750 0.43 8.238 0.596.051.11 27.804.T (in $) CFd.71 39.046.000.224 0.12.195. and implied market values over the life cycle of the project T CFe.00 0.246 0.00 CFe.43 8.195.771 0.10627 7 0.80 72.195. The implied equity market value Ve.614.767 0.T and rd = 0.02 3 4 30. (7).T) with WACCT 8 .051.06.793.10600 6 0.10549 4 0.242 0.43 8. respectively.000.24 8 30.56 94.195.06 + we.31 163.762 0.T + CFd.00 0.T (in $) Vd.10681 we.00 150.80 51.80 0.T and re = 0.754 0.195.80 137.80 124.780 0.59 44.917.195. The time-varying WACCT is computed via Eq.82 14.051.22 182.556.43 8.11 65.34 142.T and CFd.T is the time-varying debt weight (debt/total value) based on Panel A.T WACCT = ru.T-1⋅re = wd.522.00 200.T.80 26. and wd.88 119.960.524.04 34.43 30.250 1 0. (5) as WACCT = wd.12. Panel B: Implied capital structure ratios and returns over the life cycle of the project T we.T is the time-varying equity weight (equity/total value).T (in $) VT (in $) 0 1 30.145.T 0 0.220 0.051.T-1⋅0.Table 2: Scenario II (before taxes) Panel A: Annuity cash flows. and is confirmed by Eq.80 8.41 5 30.00 50.21 7. VT is the total market value of debt and equity (Vd.847.051.81 2 30. (6) calculating ru.900.93 7 30.233 0.43 8.195.T + Ve.77 91.10654 8 0. Applying Eq.80 108.764.89 6 30. the total market values of Panel A are confirmed by discounting CFT (= CFe.43 8.776 0.758 0.051.752.10524 3 0.T-1⋅0.031.762.

Panel B of Table 2 analyzes the capital structure ratios over time in scenario II and highlights several implications for the returns.Panel A of Table 2 now shows that market values (i.e.T proves to be true. Panel B of Table 2 also explains why discounting with a time-constant WACC has to fail. this observation has an impact on the WACC returns according to Eq.T + (ru. It is only the same as in Panel A of Table 1 at T = 0.T −1 re + rd (6) This built-in feature seems not very appealing.. Textbooks usually do not emphasize that the WACC can also be time-varying.T −1 w e.T −1 w e. 1958) proposition 2. WACCT = ru. Eq.[8] However. Vd.T −1 ⇔ ru.T is expected to behave over time as follows.T − rd ) w d. Confirming the irrelevance theorem again. hence exhibiting a different scenario than scenario I considered in Table 1. At other valuation dates T. First. and VT) are identical with market values given in Panel A of Table 1 only at T = 0. (6) postulates that the operating return ru. A changing WACC points at a changing capital structure over time. (5). re = ru. the use of a timevarying WACC has the advantage of an easy economic interpretation.T −1 w e. WACC increases over time. Under plausible conditions. the values differ.T. Second. Appendix B shows that under plausible conditions this is generally true. because the return to equity is supposed to be constant in this valuation exercise a very specific behaviour of the operating returns over time is implied when the capital structure is changing.T. Ve. The WACC is simply time-varying in scenario II. The NLWACC does not 9 .T −1 = w 1 + d. the debt ratio is expected to shrink over time. Third. Scenario I (rebalancing at a constant ratio of debt to market value).T w d. and scenario II (rebalancing at an implicit time-varying ratio of debt to market value) are obviously not directly comparable. Building on the (Modigliani and Miller.

The conditions set forth in scenario II are rather limiting (even when allowing for g ≠ 0%) and only then the use of NLWACC is admissible. This would be the natural choice.23) with time-varying WACCs leads to consistent results shown in Panel A of Table 2. it has to be updated. The NLWACC (and WACC) seem like a detour. the NLWACC allows to calculate the present value at T = 0 • • with a single (amalgamated) discount rate if the cash flows to shareholders and bondholders exhibit an annuity structure. This limits its economic interpretation. However. Under scenario I. the NLWACC does not help in situations where cash flows are not annuities. as typically is the case with internal rate of return procedures. N in Eq. Clearly. Vτ−1 = ∑ T =τ N ∏ (1 + WACC ) N j=τ j CFT (7) How can the modified WACC which was employed in section 2 be interpreted now? Instead of using time-varying WACCs. If one wants to use NLWACC also for prospective valuation at dates T > 0. Its use leads to consistent results. solves the problem as does the 10 .provide this information. and • if the operating cost of capital incidentally follow a specific structure to ensure a constant equity return over time (as in the no tax-case shown by Eq. discounting debt and equity annuity cash flows ($38. (4). WACC is definitely the right choice. it is not clear why under scenario II the flow to equity approach is not used instead. (3) has to be updated. The NLWACC certainly is not a return as defined by Eq. (6)). and even under scenario II a time-varying WACC (keeping the linear structure). A time-varying WACC does not share these limitations. Thus. It is an amalgamation of time-varying returns into one discount rate.247. that is.

As is well known. it is now important to specify which financing policy is pursued. to reconcile the argument taxes have to be considered. an after tax-annuity is discounted with a constant after tax-WACC to arrive at V0 = $200. In fact. 4. which implies ceteris paribus. the equity cash flows decrease while the debt cash flows increase over time. I consider a value-based debt policy only. The after tax-annuity now is $37. WACC obviously is a technique better able to handle more general situations than NLWACC. forcing the cash flows to shareholders and bondholders to be annuities portrays a rather different scenario which is investigated further in Table 4. The results again reveal that actually both flows do not conform to an annuity. Therefore. Different debt tax policies will require a case-by-case discussion. Unlike in the no tax-case. This is demonstrated for the initial example in Panel A of Table 3 showing the expected levels of equity and debt over time given the information at T = 0.80.[9] 11 . Thus. in scenario I. Analysis after taxes Modigliani and Miller (1958) have shown in their seminal work that without taxes the WACC concept does not render any additional insights in comparison to the unlevered cost of capital. Based on the calculations in Panel A of Table 3 it is obvious to compute the implied cash flows to shareholders and bondholders over the life of the project in Panel B. an alternative calculation based on the Adjusted Present Value technique (APV) is provided in Panel C.000. Again. The after tax-WACC is covered lengthy in Miller's (2007) paper. To strengthen the argument. a constant relative capital structure over time.488. For the purpose of illustration.NLWACC. the operating value (unlevered value) Vu and the value of the debt tax shield Vt are valued separately.

899.73 8 0.T.511.37 35.000.560.328.250 8 37.455.063.116.80 37.80 34.05 118.47 7.80 CFT (in $) 5 8.T) and CFe.32 160.10.854.50 142.250 0.12 leads to Ve.739.515.95 3. The debt tax shield Vd.488.739.750 0.080.21 48.06 leads to Vd. CFe.T) at date T.634.69 1.063.248.56 Vd.52 Vd.05 118.68 29.250 0.T (in $) 7. The weights are constant over time.10 6 64.260.61 1.951.750 0.00 0.511.80 7 8.70 30.488.50 1.T-1⋅rd⋅t is discounted with ru and rd to arrive at the value of the debt tax shield Vt.76 29.80 65.85 466.488.860. Discounting CFe.40 16.12 37. Ve.520.10 150.T (in $) 31.372.00 140.T is computed by discounting CFT based on Eq.112.T = Vd.T + Vt.973.T (in $) 0.125.T + Ve.28 37.25 29.21 7 33.T-1 – Vd.80 8 9.T with rd = 0.T).T) at date T.250 wd 6 37.86 7.00 182.265.250 7 37.528.00 182.627.488.80 37.T-1 rd + (Vd.T-1⋅rd⋅t (in $) Vt.06⋅0.27 Vd.75⋅0.T-1⋅rd⋅(1-t) + (Vd.T is the debt market value (wd⋅VT) at date T.488.76 34.50 142.80 0.00 912.488.40 0.797. Vd.750 0.39 8. Taxes are considered with t = 0.250 0.T (in $) 5 92.000.000. VT is the total market value (Vu.488.420.488.00 For illustration purposes a value-based debt policy is assumed.55 37.750 0.090.229.61 23. VT is the total market value (debt and equity.91 7.921.919.T (in $) 3.T according to Eq.10 7.08 6.000.750 0. and wd is the debt weight (debt/total value).27 30.872.T is the implied cash flow to shareholders during the period T: CFe.80 37.09 7.488.883.809. Vd.488.750 0.04 594.627. The unlevered firm value Vu.80 VT (in $) 200.610.000.56 816.77 200.488.923.380.T (in $) 196.12 106.04 37.488.488.18 163.834.15 452.250 0.45 93.17 849.240.20 7.99 28.547.464.239.25⋅0.39 160.80 0.565.60 30. we is the equity weight (equity/total value).T is needed.00 136.81 37.372.55 8.488. equity market and debt market value over the life cycle of the project T 0 1 2 3 4 5 CFT (in $) 37.10521 according to Eq.307.273.T-1 – Vd.03 179.79 40.T.T + Vt.T-1⋅rd⋅(1-t) + (Vd.T.97 325.T (in $) 50.82 Ve.73 25.3333.Table 3: Scenario I (after taxes) Panel A: Total market value.6667 + 0.79 2.834.250 0.396.T-1 – Vd. (8) . To compute the unlevered cash flow CFT Vd.750 we 0.00 - CFT is the unlevered cash flow during period T.T = CFT – CFd.84 69.36 65.04 89.57 8.00 170. (9) with a time-constant ru = 0.818. 12 . and N = 8. Panel B: Implied cash flows to shareholders and bondholders over the life cycle of the project T 1 2 3 4 CFd. VT is the present value of CFT given WACC at date T.750 0.080.031.T with re = 0.273.18 0.092.38 122.589.112.80 6 8.721. Panel C: Adjusted Present Value and market values over the life cycle of the project T 0 1 2 3 4 Vu.505.53 6.01 29.584.80 37.44 117.488.439.80 CFd.20 6.T is the implied cash flow to bondholders during the period T based on Panel A: CFd.37 710.00 45.18 163.229.80 37.183.T) (in $) CFe.00 0.00 0. and discounting CFd.05 93.T is the equity market value (we⋅VT) at date T.708.80 37.80 37. WACC = wd⋅rd⋅(1-t) + we⋅re = 0.45 VT = Vu. (10).12 = 0.488.

87 163.10674 8 0.12.195.046.10621 6 0.195.000.250 1 0.71 39.10066 0.616.238 0.10000 0.229 0.55 94.T at date T is the present value given CFd.793.T-1⋅rd⋅t (in $) Vt.76 142.59 44. respectively.43 8.T and rd to arrive at the value of the debt tax shield Vt.77 91.33 179.804.95 774.43 8.T and rd = 0.T-1⋅0.233 0.92 7 37.21 143.T (in $) Vd. The unlevered value Vu.40 5 30.10545 3 0.780 0.80 8.29 3.73 200.T and CFd.752.T) at date T.T + Ve.24 8 30.6667 + we.10647 7 0.776 0.10701 we.32 0.44 37.900.88 6 30.10205 0.754 0. (5) as WACCT = wd.220 0. The implied debt market value Vd. (9) with ru.88 6 37.798.952.195.031.04 34.954.383.524.767 0.T.80 0.33 142.242 0.10595 5 0.556.051.00 CFT is the unlevered cash flow during period T computed as CFT = CFe.80 26.10 557.00 0.T.07 33.T is the time-varying debt weight (debt/total value) based on the results of Panel A.195.11 65.410.43 8.348.10032 0.917.01 3 4 37.000.43 8.43 8.40 5 37.80 137. The implied unlevered cost of capital ru.78 94.739.71 182.752.T is calculated for illustration purposes in line with a value-based debt policy according to Eq.01 34.T (in $) VT (in $) 0 1 30.T is computed according to Eq.T 0 0.T-1⋅rd⋅t are discounted according to Eq.T at date T is the present value given CFe.T + Vd.764.00 150.87 2.10521 2 0.10134 0.79 2 37.749.246 0.015.556. The implied equity market value Ve.T (in $) 0 196. see Panel A.T and re = 0.09 999.10570 4 0.568.79 2 30.64 791.T wd.195.99 65.593.689.046.92 7 30.195.93 430.816.758 0.00 0.385.93 295.79 678.T + Vt.T + Vt.10242 0. and wd.21 7. t = 0.145.43 30.455.T) at date T.T-1⋅rd⋅(1-t) + (Vd.195.80 72.387.000.051.90 2.82 14.412.272.80 108.20 182.30 163.87 119.10099 0. The debt tax shields Vd.31 34. and implied market values over the life cycle of the project T CFe.764.06⋅0.T WACCT ru.596.41 407.00 151. The time-varying WACCT is computed with Eq.Table 4: Scenario II (after taxes) Panel A: Annuity cash flows.328.10 27.06.T-1 – Vd.614.T (in $) VT = Vu.948.051.00 0.00 50.00 1 37.T-1⋅re = wd. VT is the total market value of debt and equity (Vd.247.01 3 4 30.80 124.43 8.T-1⋅rd⋅(1-t) + we. (8). 13 .95 141.051.714.10169 0.762.T (in $) Vd.3333.000.27 1.T is the annuity cash flow to shareholders and bondholders. VT is the total market value (Vu.06.28 93.771 0.24 8 38.T).80 51.195.14 898.051.226.91 0.35 161.750 0.051.T (in $) CFd.960. Panel B: Implied capital structure ratios and returns over the life cycle of the project T we.75 118.614.T-1⋅0.051.762 0. rd = 0.051.11 1.095.T is the time-varying equity weight (equity/total value).33 21.12.00 CFe.43 8.793. Panel C: Adjusted Present Value and market values over the life cycle of the project T CFT (in $) Vu.00 200.522.847.82 65. (10) with ru.739.224 0.87 119.T (in $) Ve.

T-1 ⋅ rd ⋅ t (1 + ru ) (1 + rd ) T −τ . again. j ) N CFT (9) In the special case of a time-constant ru.T ⎟⋅ ⎠ w e. 14 . values are different. the formula is easier: Vu. and is therefore discounted with the unlevered cost of equity apart from the cash flow of the previous period which is certain. the value of debt has to be subtracted from the total market value (Vu + Vt).T-1 (8) The unlevered value is computed with the unlevered cost of capital as follows: Vu.Miles and Ezzell (1980) and Kruschwitz and Löffler (2006) show for this policy: ⎛ rt ⎞ w re + rd ⋅ ⎜1 − d ⎟ ⋅ d. The value of the debt tax shield is risky given this financing policy.T-1 ⇔ ru. hence exhibiting a different scenario than scenario I considered in Table 3. j d N Vd.τ−1 = ∑ T =τ N (1 + ru ) CFT T −τ+1 . The APV approach confirms the consistency of the calculation in Panel C of Table 3.τ−1 = ∑ T =τ N ∏ j=τ (1 + ru. To arrive at the equity value.τ−1 = ∑ T =τ Vd. Vt. Scenario I (rebalancing at a constant ratio of debt to market value) and scenario II (rebalancing at an implicit time-varying ratio of debt to market value) are.T-1 ⎛ rt re = ru.T-1 ⎝ 1 + rd ⎠ w e. not directly comparable.T − rd ) ⋅ ⎜1 − d ⎝ 1 + rd ⎞ w d.τ−1 = ∑ T =τ N ∏ (1 + r ) (1 + r ) N −1 j=τ u. Under scenario II (forced annuity structure) Panel A of Table 4 exhibits that market values are identical with market values given in Panel A of Table 3 only at T = 0.T-1 ⋅ rd ⋅ t (10) Simplifying with a time-constant ru leads to Vt.[10] For other valuation dates T.T + ( ru.T-1 = ⎛ rt ⎞ w 1 + ⎜1 − d ⎟ ⋅ d.T-1 ⎝ 1 + rd ⎠ w e.

15 . indeed. Third. For example. It is only the same as in Panel A of Table 3 at T = 0. Second.91 + = 407. because in this valuation exercise the return to equity is supposed to be constant a very specific behaviour of the operating returns over time is implied when the capital structure is changing. discounting unlevered cash flows with time-varying WACCs leads to results consistent with Panel A of Table 4.6 = 295. The unlevered cost of equity increases over time. 1. Thus. and also confirms the results of Panel A and B. this built-in feature seems not very appealing. WACC increases over time. First. WACC is simply timevarying in scenario II. (10) as: Vt. Miller’s (2007) claim that in the tax-case the integration of the interest tax shield in the WACC formula seems misplaced does not have to be followed. The arguments already established in section 3 can be analogously repeated.06 The analysis underlines that in the tax-case the situation is not getting any better for the NLWACC and the aforementioned results hold in principle. The time-varying WACC approach proves this fact.06 1.21 151. the debt ratio is expected to shrink over time again.10674 ⋅1.99 . Again. (5). the value of the debt tax shield at the beginning of period 6 is calculated based on Eq. Additionally. The NLWACC does not provide any information about the changing capital structure. this observation has an impact on the WACC returns according to Eq. The APV calculation in Panel C of Table 4 confirms that operating returns are time-varying.Panel B of Table 4 analyzes the capital structure ratios over time in scenario II and highlights several implications for the returns. Panel B of Table 4 also explains why discounting with a time-constant WACC has to fail.

this is a question the WACC does not necessarily have to approach. Therefore. However. 2) Given the special valuation scenario for which the NLWACC is motivated. How do more realistic tax regimes with personal taxes influence tax shield valuation? Which terminal value calculations are plausible? These and others seem to be more pressing questions which deserve further attention in future research. It does not seclude itself from an economic interpretation. the foundations of WACC are sound. valuation is still a field which has many promising research questions to offer.5. 16 . the flow to equity approach is the direct solution while the (NL)WACC is a detour. Summary and outlook The claim that the NLWACC is conceptually superior to a constant WACC seems for two reasons rather artificial: 1) A slightly modified WACC which is time-varying is conceptually superior to the NLWACC. Just to name a few: Which debt policies can be empirically supported? Given its autarkic nature.

This can be repeated for VN-2.N-2 1 + WACC N −1 CFN −1 CFN + 1 + WACC N −1 (1 + WACC N −1 )(1 + WACC N ) By recursion. Starting with the value in the next to last period: VN-1 = Ve.Appendix A: Derivation of time-varying WACC The following derivation draws on the proof of a time-constant WACC by Brealey et al. The total cash flow to debt and equity investors is the cash flow CF plus the interest tax shield: CFN + t ⋅ rd.N-1 ⎟ ⎝ ⎠ Equate both definitions and solve for VN-1: VN −1 = CFN CFN = 1 + rd.N −1w e.N + re.N −1w d.N w e. 533.N-1 Ve.N −1 ⋅ Vd. (2008).N (1 − t)w d.N-1 ) ⎜ Ve.N-2 + re. As the return-definition is based on Eq.N w d.N-1 + Vd.N-1 Ve.N-2 + re.N −1w e.N −1 .N ⎟ = VN −1 (1 + rd.N-1 + re. This total cash flow can also be written based on returns: ⎛ ⎞ Vd. (5) shows up.N-1 + re.N-2 ) Solving for VN-2 yields: VN − 2 = = CFN −1 + VN −1 CFN −1 + VN −1 = 1 + rd. (4) the next period’s payoff includes VN-1: CFN −1 + t ⋅ rd. p.N −1 (1 − t)w d.N-1 . one obtains for any arbitrary valuation date τ–1: Vτ−1 = ∑ T =τ N ∏ (1 + WACC ) N j=τ j CFT (7) 17 .N-1 1 + WACC N The WACC-definition of Eq.N w e.N ⋅ Vd.N-1 + Vd.N-1 VN −1 ⎜1 + rd.N − 2 + VN −1 = VN − 2 (1 + rd.N-1 + Vd.

T −1 . e.T − Ve.Appendix B: Is the debt to total market value ratio falling over time? To show the conditions for this relationship.T decreases over time. the equity growth rate is: g T (Ve ) = Ve.[11] N −T 18 . Inserting Eq. Therefore. I compare growth rates of debt and equity market value. If debt is not growing as strong as equity. the debt ratio has to shrink.T −1 Ve. wd. (2) yields the following growth rate: ⎡ (1 + g) N − T ⎤ ⎡ (1 + g) N − T + 1 ⎤ ⎥ CFe ⎢1 − ⎥ CFe ⎢1 − N −T ⎢ (1 + re ) N − T ⎥ ⎢ (1 + re ) N − T + 1 ⎥ ⎡1+ g ⎤ ⎣ ⎦− ⎣ ⎦ 1− ⎢1 + r ⎥ re − g re − g e ⎦ ⎣ g T (Ve ) = = N −T+1 − 1 ⎡ (1 + g) N − T + 1 ⎤ ⎡1+ g ⎤ ⎥ CFe ⎢1 − 1− ⎢ ⎥ ⎢ (1 + re ) N − T + 1 ⎥ ⎣1 + re ⎦ ⎣ ⎦ re − g For the debt growth rate equivalently: ⎡1+ g ⎤ 1− ⎢ ⎥ ⎣1 + rd ⎦ g T (Vd ) = N −T +1 − 1 ⎡1+ g ⎤ 1− ⎢ ⎥ ⎣1 + rd ⎦ Under realistic conditions ( rd < re ) equity growth rates are higher than debt growth rates.g.

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Harris.. (Stowe et al. Then. for the UK. see Bruner. [11] Except for N → ∞. & Röder (2008). [4] The present value then is $200.. Essler. Niermeier. [9] For other policies see (Kruschwitz and Löffler. (5) can be found in Appendix A. The returns are different. and Graham. and thus needs not be shown here. [5] See (Miller. see Lobe. (Copeland et al. as different tax situations are considered in Table 2 and 4. [7] A derivation of Eq. 1997). The derivation incorporating g is straightforward. 2005). 8. … . (Brealey et al. [2]For the US. of course. CF (1+g)N-1 = CFN. 2006). (Titman and Martin. Therefore.g.000.384. 22 . (Daves et al. Eq. (Campbell et al. & Hatzopoulos (2000). [3] The following geometric series is evaluated: CF = CF1. CF (1+g) = CF2. & Harvey (2001). & Higgins (1998). and for Germany. (23) for g = 0%. and T = N. p. see Arnold. (Koller et al. 2007).. (Lundholm and Sloan. [8] See.42 which is marginally higher than the true present value of $200. [6] See e. Eades. 2007).Endnotes [1] For ease of exposition the notation of Miller (2007) is adopted. 2004). 2008).. gT(Vd) = gT(Ve). also the weights in Panel B of Tables 2 and 4 are the same. 12. [10] Panel A of Table 4 is identical with Panel A of Table 2. 2005).. Expectation operators are therefore also dropped. 2008). 2004). for example. p..

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