American Finance Association

Interactions of Corporate Financing and Investment Decisions--Implications for Capital

Budgeting: Reply
Author(s): Stewart C. Myers
Source: The Journal of Finance, Vol. 32, No. 1 (Mar., 1977), pp. 218-220
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/2326920
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THE JOURNAL OF FINANCE * VOL. XXXII, NO. 1 * MARCH 1977

REPLY

STEWART C. MYERS*

IN HIS "COMMENT" [1], Professor Bar-Yosef shows how a weighted average cost of
capital can be calculated from the "textbook formula," apparently under less
restrictive assumptions than those given in my paper [2]. But he does not show that
the calculation yields a number that is generally useful in capital budgeting.
Moreover, there is an important assumption hidden in his proofs.
The specific problem I addressed is whether, or under what conditions, the
textbook formula gives the correct hurdle rate for evaluating capital budgeting
opportunities. Bar-Yosef and I agree that the general rule is to accept projectj if
adjusted present value is postive (APVj > 0). We also agree that one way
calculate adjusted present value is to discount the project's expected after-tax
operating cash flows (Cj,) at the appropriate cost of capital, p7. The project
accepted if its net present value is positive (NPVj > 0). This works if pJ* is define
that discount rate for which'

00 Ci
NPV_ (I >0 if andonlyif APVj >0.
t=0 (I+(1))
That is, p* is the minimum accep
which APVj = 0.
The issue is whether pJ can be

pJ*=r(I -T)( 1~ +cy )+k( 1 )(2)

Here r is the current borrowing rate, T the marginal corporate tax rate,2 k the
equilibrium capitalization rate for the firm's stock, and a =B/S, the ratio of the
aggregate market values of the firm's outstanding debt and equity. The hat (^)
indicates a proposed or estimated value for pJ*.
I concluded that discounting at the textbook PJ* is fully valid only if sever
assumptions are satisfied. Bar-Yosef argues that three on my list can be dropped,
namely (1) that projectj is a perpetuity, (2) that it makes a permanent contribution
to the firm's debt capacity, and (3) that the firm in aggregate is a perpetuity. He
states that "the results of the textbook formula based on the remaining 4 assump-
tions are identical to the results of the APV method."
I cannot see how this follows from Bar-Yosef's analysis. He considers the
valuation of the firm in aggregate, not the change in value when additional capital

* Sloan School of Management, Massachusetts Institute of Technology.

1. This is the "weak" definition of the cost of capital. See [2], p. 7, Eq. 7a.
2. I agree with Bar-Yosef's analysis for a no-tax world (Section I of his paper). My reply is confined to
the case in which T is positive.

218

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 Reply 219

projects are taken on. How can assumptions (1) and (2) be dropped without even
bringing projectj into the analysis?
Bar-Yosef's argument, for the most general case,3 is essentially the following.
Assume first that VO, the current market value of the firm (debt plus equity) can be
written as:

oo C
vo = E t . ~~~~~~~~(3)
t=- (I +P*)

In other words, Bar-Yosef defines p* as the discount rate which explains the firm's
current market value, given its stream of expected after-tax operating cash flows.
(In his notation, C, is X (I - T) + TAL.) Second, assume that p* does not shift as time
marches from t = O to t = 1, so that

Cl+ V1

where:

oo CC

t=2 (I +p *)t

V1 is the expectation at t = 0 of the firm's value at the end of t = 1. Then he shows

that p* is a weighted average of k and r, the equilibrium expected rates of return on
the firm's stock and bonds over the period t = 0 to t = 1.

p* = ( 1-T)r (a c + k ( 1+ )
If the argument is repeated for the interval t = 2 to t = 3, t =3 to t = 4, etc.,
relationship is found.
This may appear to rescue the textbook formula, but it does not. My paper
showed that the p* which satisfies Eq. 3 depends, in general,4 on the pattern of the
firm's expected cash flows over time, just as the proper hurdle rate for a project
depends on its cash flow pattern. Thus, even if the correct p* could be observed via
the textbook formula, the rate obtained could be applied only to projects having
the same cash flow pattern as the firm undertaking them.
For example, suppose that a particular firm is a perpetuity. Investors look
forward to an infinite and constant stream of expected cash flows. We know that
the textbook formula works for this case, so we use it to calculate p*. This number
is the appropriate hurdle rate for a project which is likewise a perpetuity, but it is
not the appropriate hurdle rate for a project offering any other cash flow pattern.
The proper hurdle rate for the project does not depend on the firm's cash flow
pattern, but the firm's pattern affects the rate observed via the textbook formula.
To repeat: if we can observe the correct p* for the firm (as defined by Eq. 3)

3. See Section II(C) of his paper.

4. See [2], pp. 10-13.

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 220 The Journal of Finance

then this rate is the correct capital budgeting standard only if the expected cash
flows generated by additional investment are proportional to the flows generated
by the firm's existing assets.5 That is, we must have C,= hjCt, where hj i
constant.
The next issue is whether the correct p* for the firm can be calculated from the
textbook formula. We know it can when the firm is a perpetuity (C, = C, t = 1
2,..., oo), and also when the firm lasts one period only (C, = 0, t > 2).6 In these
cases Eqs. 3, 4 and 5 are known to be consistent. Bar-Yosef seems to show that the
equations are consistent for any cash flow pattern. However, there is a hidden
assumption in his proof. Eq. 5 follows from 4, but except in the two special cases
just noted, 4 does not follow from 3. Bar-Yosef gets from Eq. 3 to 4 by assuming
that p* does not change as time passes. Now, unless the firm is in a steady state the
cash flow pattern viewed at t = 1 will not be the same as viewed from t = 0. Since p*
depends on the cash flow pattern, it will, in general, vary as time passes. By taking
p* to be constant over time, Bar-Yosef has in effect assumed away the problem.

SUMMARY

Professor Bar-Yosef presents the traditional argument for the textbook formula in
a clear and relatively elegant way. Unfortunately, he fails to recognize an impor-
tant implicit assumption of that argument, namely that the appropriate cost of
capital for a firm or asset depends on its cash flow pattern.
On the other hand, he is right to criticize my list of "necessary and sufficient"
assumptions for using the textbook formula as a capital budgeting standard.
Instead of the three assumptions noted above, I should have concluded as follows.
The textbook formula gives a valid hurdle rate, at least in certain special cases, if
the project under consideration has the same cash flow pattern as the firm.7 Three
special cases have been identified thus far. They occur when (1) the firm is entirely
composed of one-period assets, when (2) the firm is a perpetuity, and when (3) the
firm is on a steady-state growth path (C, = CI(l + g)t- 1). The third case was no
mentioned in my paper, but its existence is clear from Bar-Yosef's proof.

REFERENCES

1. Sasson Bar-Yosef. "Interactions of Corporate Financing and Investment Decisions-Implications

for Capital Budgeting: Comment." Journal of Finance, this issue.
2. S. C. Myers. "Interactions of Corporate Financing and Investment Decisions-Implications for
Capital Budgeting." Journal of Finance, 29 (March 1974), 1-25.

5. The firm's p* might nevertheless be an acceptable approximate hurdle rate. See Section IV of [2].
6. The validity of the textbook formula for perpetual cash flow streams is well known. The one-period
case is discussed in my paper ([2], pp. 12-13).

7. Of course there are other assumptions discussed in [2] but not mentioned in this "Comment" and
"Reply."

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