RETURN AND VALUE OF AN INVESTMENT

TWO QUESTIONS AND ONE ANSWER

Carlos Antonio ALIBERTI(*)

This article introduces an analysis and interpretation of the commonly used indicators for the
investment projects evaluation. As a conclusion its adequacy for business purposes is reaffirmed, but
when applied to the evaluation of social, public or environmental projects its scope is relativized.
Particularly in reference to the first issue, about commercial decisions, the adopted indicator allows to
make progress in the understanding of the benefit of the financial leverage as a means to increase the
efficiency of the owned invested capital. The explanation of these matters is developed through the
following points:
1. The benefit of a project, two questions.
2. Assumptions and symbology for one answer.
3. Self-generated incomes distribution and the firm’s value.
4. The certainty equivalent and the cost of the owned capital.
5. The NCR as an efficiency indicator of the owned money invested.
6. Limits to the normal debt.
7. Financing and investment
8. Debt or equities’ subscription?
9. Comments on the answer.

1. The Benefit of a Project, two questions

Which may be the benefit to be achieved in an investment, whenever money’s return is just its
opportunity cost? This question contains an assertion or, even more, a tautology which deserves some
reflections before it is answered.
By its very nature, a financial investment can only return its opportunity cost. This happens
because the price to enter into a financial position, like to buy equities or bonds, is what defines the
cost of money in the terms of the interest rate which links that price with the expected inflows those
securities will provide. This interest rate represents a proportional return claimed to wait for future and
sometimes risky money. It denotes an opportunity cost in the sense that, since this rate derives from a
security priced at an “equilibrium level”, it defines the yield to expect from an alternative opportunity of
financial investment with similar delay and risk which could be accomplished instead.
As we know, a productive investment on the real sector of the economy is a different matter
but, however, the business desirability in a monetary economy is also defined by the cost of money:
money is not only useful to watch the relative prices among goods, but it also enables us to deal with
our expectancy about future, in terms of time and risk costs incurred in doing so. But the core
difference leans on the fact that the flow of money that an economic activity will provide along time
does not have a financial origin. On the contrary, it is the activity itself what creates the financial flow
which may be negotiated at the financial market. Therefore, this actually defines the meaning of a
project evaluation: to look for an activity which is worth more than its cost. In other words, the bargain
is to pay for a real investment an amount lesser than the financial present value of the cash flow it will
provide, with a plain way to gather the benefit:
 once the investment was made, the assets -equities- which grant the right or claims over the firm’s
results are valued as a financial matter. So, if we get a value or Worth greater than the amount
initially invested in fixed o real assets, we can realize that difference simply by selling our financial
assets.
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To this last respect, the financial instruments state the minimum return to be claimed over a
project or, in other words, its opportunity cost. Thus, as a matter of fact, what we need for the
evaluation process is to know how much a real investment exceeds its opportunity cost.
Money, as the first financial asset, is link between the real and the financial world. As money
1
acts as “unit of account”, “store of value” and “mean of payment”( ), it enables us not only to compare
values between goods at present but also to compare values through time, as money’s cost denotes
the costs of time and risk for business purposes. To this respect we need to realize that the
comparisons made in the terms of the present prices for goods are an expression of the relative prices
prevailing among those goods. But, given a set of prices, the comparison between future and present
2
only denotes the relative cost of money( ). It’s by means of money that we state a value which is
dissociated from real assets to become a strictly financial one. Concerning the future in business,
there is only one possible assertion today: how much we will pay for the future in terms of money,
because the money trade off for time and risk means that we can trade at present with our expectancy
about future. Notwithstanding this, “expectancy” bears an influence on two aspects:
 Besides our common assumption about market equilibrium prices for goods reflect only production
costs and customer’s utility -in concordance with a static analysis-, those prices also add the
expectations from both, producer and consumer, about the future prices. In this sense, over a
single good, expectations are discounted at present.
 For a business, where a certain relationship among the prices for different goods -the relative
prices- defines the profit’s expectancy, the risk of changes in those relative prices -the changes in
the micro and macroeconomics factors which may alter them-, is bore as a premium over-rate to
discount the expected benefits.
We can emulate at present different future economic scenarios, perhaps, one of them
replicating the one which will become true. Hence, at least we can be pricing future accordingly with
the probability distribution of the prospective scenarios. Notwithstanding, this doesn’t imply we will
succeed in guessing any future price, set of prices or benefits, meaning only that we found a
systematic procedure to form and shape a “rational” expectancy ahead to be bore on the present
prices.
3
The expected Net Benefits NB from a project along time( ), nominated in money, are evaluated
by comparison with the present amount of money needed to invest in real or fixed assets to carry out
the project. The strictly correspondence between the financial assets value and the expected net
benefits to be provided by an economic activity can be demonstrated, at least with a conceptual scope,
working with the same structure of assumptions adopted in the context of the Modigliani and Miller’s
4
analysis( ). For it, the starting point is to apply this analytical framework to look out for the meaning of
the commonly used indicators for project’s evaluation purposes. Hence, first we will need to review the
two outstanding criteria used for evaluation, the Net Present Value NPV and the Internal Rate of
Return IRR. Although they are not the only ones which may be taken into account, from a firm’s point
of view (private investment at risk) these are necessary financial indicators to consider before making
decisions.
Despite the current use of the above mentioned indicators, sometimes we may observe an
inaccurate interpretation about which is the greater return that we can get from a project and how it will
be perceived. For example, where and how will the entrepreneur obtain the results pointed out by the
evaluation’s process? With respect to this matter, as it was already suggested, the benefit can be
realized at the market by selling the financial assets representative of the project. But, also, the
proposition of this paper is that an effective measure of the efficiency of an investment is given by the
association of its “internal” return with the prevailing conditions at the financial markets. In this way the
5
coefficient NPV/I ( ) is an expression which links in relative terms the IRR with the effective cost of
money “r” for a project. This is an efficiency indicator because it provides a relative measure of the
capitalization to get over each dollar of the owned money invested. In itself, the NPV alone is the
monetary expression of the amount of a capital gain, or Worth surplus, provided by the financial
market over the the project’s investment. To understand this criterion, first of all it will be necessary to
distinguish between the meaning of the NPV and the IRR, alternatively applied to value a financial
instrument or to value the results derived from a real investment.
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The whole expected results over time, derived from an investment, may be valued either at
present or at any other future moment. Anyway, the inter-temporal equivalence in the values of the
inflows to be perceived at each considered period comes from the cost of money, given as the
opportunity cost of the time to wait for, and the risk of not perceiving, the expected revenues at the
estimated dates. This is strictly a financial procedure just allowed by the functions of money as store of
value and as means of payment providing, therefore, a pattern to differ payments. So, it is allowed to
state a trade off between an amount of money and the time and risk to perceive it.
A financial instrument, like bonds or equities, represents the rights or claims over future
payoffs, and its “equilibrium” price “p0” is then depicted as the present value of the future money to be
perceived. According to this, paying p0 dollars to get future revenues of an identical present value,
simply means an operation with NPV=0 (a Net Present Value equal zero) in the terms adopted for a
project’s evaluation. This reflects the fact that the return on a financial investment is nothing more than
“r”, the expected rate of return on money.
Now, if we consider a financial instrument according to what we have just stated in the former
paragraph, what does the IRR mean? It is the same than the “Yield To Maturity”, the average return
6
expected from a succession of payments along time( ). If at different periods we consider a constant
opportunity cost for money r, this unique rate r will be the same than the IRR or YTM of the financial
asset. It doesn’t matter if the amount of money to get differ from one period to another. But at financial
markets money has not the same cost at different periods, as evidenced by the Term Structure of
Interest Rate, TSIR. Hence, having or not a constant amount in the payoffs’ schedule, the average
return of money reasonably differs from any of the pertinent rates to actualize each payoff. In this
case, the IRR simply indicates an average rate, as well as the YTM, with respect to the price of the
financial asset.
Then, why does a profitable project has a positive NPV? Because the flow of Net Benefits NB
to be obtained from an investment “I” must be valued in terms of the opportunity cost of money to
determine the whole Net Benefits Present Value, “NBV”. So, we take this amount NBV as the financial
value of the project’s expected returns. However, to get the NBV, the amount “I” needs to be paid at
present, while the same amount “I” also represents the money to pay for a financial instrument to get
only the market return on money. Hence, the surplus profit from the project over a financial asset may
be settled as the difference
NPV Ζ NBV ϑ I [1]

Hitherto, if we want to identify a profitable project it is necessary to identify a real investment “I”
of an amount smaller than the financial present value of the future expected returns, NBV. The
difference between both values will be a net gain to get from the capitalization of the financial assets
representative of the rights on the project’s benefits. This means a capital gain, as a stock and not as
a flow of returns, because the owner of the new firm has both sorts of Worth -the real and the financial
assets-, having paid for them only the price “I” of the real ones. Although both kinds of assets allow to
get a flow of benefits, the right to perceive them is always financial and may be sold at market as a
stock which adds the stream of future returns. Inversely, let us suppose -without transactional nor
liquidation costs- that the expected net benefits have a less present value than the real assets which
reproduce such benefits. What kind of assets should we sell?
Applied to projects evaluation, the IRR is the rate which generates an NBV equal to the value
of the investment “I” and, consequently, it derives a zero value for the NPV, as with a financial asset.
But, while $I may be an amount to invest to get the market returns on money, neither the project’s
7
NBV I ( ) nor the IRR are representative of any operation at the financial markets and, as a
consequence, they are not representative of any cost of money. This fact is exactly the meaning of the
IRR as an “internal” return to the project: it’s a rate divorced from the financial markets.
Now, let us suppose a project whose yield were a flow of expected average net benefits, NB,
identical from one period to the other and for a succession of periods tending to an infinite horizon. As
the residual value on the investment would be perceived at the end, its present value would tend to
8
zero ( ). Also, for the aim of this stage of the analysis, it is assumed that the entrepreneur takes no
 4

financial leverage, and pays the investment only with his or her owned money. Under these additional
assumption the project’s and the entrepreneur’s returns are the same, and can be valued as a
perpetuity. Therefore, we get
NB
NBV Ζ [2]
r

where “r” (9) denotes the pertinent market opportunity cost of money. In turn, by definition of the IRR it
is
NB
IΖ [3]
IRR

As the NPV is the monetary measure of the financial gain in terms of the capitalization of the
future expected benefits, its quotient on the investment “I” is a relative measure of that yield with
regard to each $ brought into the project. This last indicator may be stated as
NPV NBV ϑ I
Ζ [4]
I I

About the expression [4] we need to note that the Net Benefits Present Value must point out
the value of the financial instruments giving the right to perceive them, that is to say, the equities
value. With respect to the investment in real or fixed assets I, in line with the adopted assumptions for
this stage of the analysis, its amount represents exactly the same than the accountable concept of Net
Worth, NW. As a consequence, the NPV/I coefficient strictly denotes the relative difference between
the financial assets FA and the real assets RA or, which is the same, the relative difference between
equities and the Net Worth belonging to the entrepreneur:
NPV FA ϑ RA Equities ϑ Net .Worth
Ζ Ζ [5]
I RA Net .Worth

On the other hand, in terms of rates, by substituting NBV and “I” on the right side of [4],
respectively, with the right sides of [2] and [3] and operating we obtain that
NPV IRR ϑ r
Ζ [6]
I r

This result means that the quotient between the NPV and “I” also shows us the relative
difference between the project’s internal rate of return and the opportunity cost for money, with regard
to this last rate. Therefore, under the assumptions of this analysis, comparing [5] and [6] we find that
the NPV/I Coefficient points out the Net Capitalization Rate -NCR- provided by the financial assets and
to be get over each $ invested in real assets:
NPV FA ϑ RA IRR ϑ r
NCR Ζ Ζ Ζ [7]
I RA r

With respect to the relationships depicted by [7] and clearing the IRR from expression [3] we
get that it is IRR=NB/I, the internal rate of return emerges as the same concept that the Return on
Assets -ROA- for a firm. This means that the financial surplus value of the firm over its fixed assets is
defined by the exceeding rate of return of its business over the market cost of money.
As a concept, the Net Capitalization Rate brings us a link between the fixed assets value and
the value of the financial assets. In concordance with [7] we can clear away that
FA Ζ RA(1 Η NCR) [8]

Although it may seem a trivial assertion we got as a conclusion that, as greater the stream of
benefits of a project (firm) the greater is the value of the owned Worth in the terms of the financial
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assets which represents the rights over that project (firm). Or, in other words, to maximize the
expected benefits is the same than to maximize Worth. This proposition holds yet for a world with
uncertainty, anywhere we identify the pertinent market opportunity cost of money.
Additionally, with [7] we observe that as greater is the cost r for the money invested in real
assets, lesser will be the financial capitalization to get. With this we corroborate the acceptability
conditions commonly stated for a real investment: the desirability of a project is based on a return
greater than the cost of money, as a condition to obtain a Net Present Value greater than zero,
NPV>0. To this respect, we need to take into account that the Gross Capitalization Rate, GCR, simply
denotes the quotient of the IRR over the cost of money, or the quotient of the financial asset’s value
over the value of the real assets. It is important to note that this last quotient represents the same
concept of a familiar business cycle indicator, the Tobin’s q, which expresses the ratio of the
capitalized value of a unit of investment to the purchase price -or reposition value- of the necessary
real assets.
On the one hand, our first step was to grasp the concept of the project’s NPV as a matter which
really gets existence through the market, not to be only an abstract measure of desirability. On the
other hand, the NPV/I coefficient or Net Capitalization Rate, becomes an effective measure about the
efficiency of the owned capital invested, relating the expected return from the project with the cost of
IRR ϑ r
money. Now, it’s necessary to realize that determining as the capitalization rate is sustainable
r
only under the initial assumptions. For a finite extension of periods instead, and considering the
equivalence between the expressions
n
NB 1 ϑ (1 Η r ) ϑ n
å
i Ζ1 (1 Η r )
i
Ζ NB
r

we can clear out that the relationship between the project’s return and the cost of money adjusts to
IRR 1 ϑ (1 Η r ) ϑ n
NCR Ζ . ϑ1 [9]
r 1 ϑ (1 Η IRR ) ϑ n

But, if the net benefit expected for a particular period differs from another one, NBiNBj , the
pertinent calculus to apply is
n
NBi

(1 Η r ) i NPV
NCR Ζ n
i Ζ1
NBi
ϑ1 Ζ [10]

i
I
i Ζ1 (1 Η IRR )

With respect to the situation depicted by [10] we need to take into account that it is
NBV Ζ f ( NB , n, r ) and ( NBV  I ) Ζ f ( NB , n, IRR ) . For each case the function of both expressions
is exactly the same and the only change is the rate adopted as an argument. Hence, it is the
differential between both rates what explains the difference between each obtained value. Obviously,
once the concept has been stated, it is only necessary to determine the quotient NPV/I to know the
“Net Capitalization Rate” to be achieved through the financial assets representative of the project in
regard to each $ invested in fixed assets. The key variable is the opportunity cost of money attributable
to the project. If a correctly identified “r” gives as result a positive NPV, the IRR necessarily will be
greater and it doesn’t matter how difficult to calculate the internal rate could be. But in the real world
the true complexity is to determine the adequate cost of money to anticipate the investment value and
not to find the IRR. Perhaps, this is precisely the reason which advocates in favor of the internal rate
as an outstanding indicator: with greater or smaller estimation complexity, it only leans on the
investment amount and the forecasted stream of benefits and so, if reasonably high, a lower r could
be assumed.
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Once a project has been developed, strictly in terms of the monetary value it must be
indifferent for the entrepreneur to get the expected benefits at present, by selling his or her shares, or
to wait until the expected flow of incomes is verified in time. But, to achieve this target, he or she relies
on the confirmation at the market of the previously made evaluation. Technically, the NPV is a correct
way to determine the surplus money to get over the initial investment, because the cut-off rate “r”
provides a link between the real and the financial sectors of the economy. To verify this, r needs to
capture the core of finance, the risk and time values that market will apply to discount the expected
returns.
The meaning of the “NCR” merits now another reflection. Any firm has two market values (10):
 the reposition value, determined as the value of the real and intangible assets needed by the firm to
perform its activity, and
 the reproduction value, which is the present value of the future money to be reproduced by the
firm’s activity. This is the value of the whole financial assets representing the private claims over the
firm.
Consequently, when we compare the net benefits present value with the value of the
investment in productive assets, we compare the financial value of future incomes with the amount we
need to spend in fixed assets. In this sense, the meaning for project’s evaluation is stated in
strictly financial terms, as the comparison between the present value of future money and the
present money applied to the investment. And, finally, within this context for the analysis, the last
comment leads to two questions,
1. What is relevant to evaluate the situation of an entrepreneur facing a project? The value of the
whole financial assets representing the firm by means of the Weighted Average Capital Cost? or,
The financial capitalization of the entrepreneur’s owned Worth in terms of the effective opportunity
cost over the owned capital? The efficiency of an investment at risk may be measured throughout
the Net Capitalization Rate that it provides, accordingly to its activity based and financial risk.
2. Is it really meaningful the Cost-Benefit Analysis, in its traditional use, for the evaluation of social or
environmental projects as well as for public decisions? For private projects at risk, dealing with the
market, there is a true possibility to get anticipated earnings from a good investment. But nobody
can anticipate the benefits to be perceived from any future output of collective goods and services.
Moreover, the determination of monetary costs and benefits reflects a certain structure of relative
prices, which is allowed by the function of money as “unit of account”. Then, if the only way to
perceive social benefits is to wait for the moment when they will happen, the relevant relationship
between costs and benefits will be the prevailing in concordance with the future relative prices. But,
on the one hand when determining a future stream of benefits, they usually comes out from the
11
present structure of relative prices( ) projected upon time. On the other hand, a single projection
leans on a microeconomics analytical scope which narrows the possibility to reflect its input-output
impact over the relative prices of the whole economy.
As we will see later, an answer to the first question is easier to get through the analytical
framework provided by Modigliani and Miller but instead, the second one, implies a greater effort. To
this last respect, it seems necessary to depart from a “fundamentalist” conception of the cost-benefit
analysis to broader the categories for the evaluation of actions through its effects over an economic
and social situation. In this sense, the “Cost-Impact Analysis” shows an alternative methodology for
12
project’s evaluation, focusing on the cost’s effectiveness ( ) to achieve a specified target. The
evaluation of an investment decision looks for its economic rationality. When we refer to the business
world, the Cost-Benefit Analysis with its alternative procedures (13) confirms its adequacy to evaluate
monetary profits when the decision is made. Instead, the economic rationality for a public investment,
or the consequences of any action over our environment, may be requiring a deeper understanding of
which are the affordable costs facing a qualified expected result.
14
These reflections require an open-minded attitude towards the words of Jack Wiseman ( )
about “the necessity of a new kind of economics” to reckon uncertainty about future. And, when we
take this point into account, is it only an academic need the one we have to continue researching on
our theoretic power of analysis? On the ground of facts, there are also more pragmatic expressions of
this necessity. The standards of the ISO 14.000 Series (and their origin, the British Standard 7.750)
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denote the strain to improve the firm’s environmental management going beyond our current
principles for the Cost-Benefit financial Analysis.
Temporal variables are in scale with the object of analysis and a century is too much time for a
human life. Our use of the “financial scale” is in line with this matter and any amount of money beyond
the common life expectancy for our kind has a little value at present. This is easily to be proved when
discounting a future income, far from now, in terms of the cost of money. So, this fact points out the
necessity to review some of the concepts we usually apply to evaluate economic decisions, for
example, in the ground concerning our environment. To exhaust land’s reproduction capability may be
good for present and future business, anytime a rising marginal production cost could be overwhelmed
by the increase in the price for food. A result of this kind only denotes the present monetary profits for
the entrepreneur who will exhaust land, and yet a better business prospective for those who kept the
soil’s reproduction capability. But, from the point of view of a growing global population this may not
seem a rational economic procedure. The reason of this problem lies on the fact that our financial
analytical framework only takes into account the resources allocated and employed in terms of the
present time. For example, when we find the advocation for the use of “Pareto compensations” to
justify environmental damages, an important matter is to have a clear knowledge about how those
compensations can be determined with respect to the future generations.

2. Assumptions and symbology for one answer (15)

The concept of financial capitalization led us to two questions. Now we will intend the answer to
one of them, by developing a criterion to evaluate the benefit from financing when a productive
investment at risk can be accomplished. The Modigliani and Miller’s Model will be an obliged reference
for this analysis, inasmuch as it introduced an explicit recognition of risk for the valuation of business
decisions and its financing. In order to place us into the same context commonly applied to deal with
the capital structure of the firm, we must add the following assumptions to the foregoing.
Assumptions:
 We will assume that there is no depreciation for fixed assets. The reason is not to simplify the
formal treatment, but to get a firm’s cash flow after interest and taxes which is identical to the one
going to the hands of the shareholders. Thus, we do not have to settle whether the relevant stream
of benefits is the cash flow or the dividends.
 Indebtedness is always assumed within levels without any default risk on the part of the firm, and
at a cost equal to or near the risk free rate.
 Except for the cost of the owned capital, variable in the terms of the financial risk that it bears as a
function of the leverage level, all the others rates are assumed to be constant.
 We will only consider the effect of income tax over the firm’s benefits, disregarding taxes over
personal incomes.
 Money is lent or borrowed at the same rate by selling or purchasing bonds.
 There is no friction at the financial markets, that is to say, there are not any kind of transactional
costs for any securities.
 In general, we assume perfect markets operating under strong efficiency conditions.

The following symbology was adopted for the formal treatment of the expressions,
In general
R interest rate or opportunity cost of money
V present value of a future stream of money, that is, discounted accordingly to its
opportunity cost
U as sub or supraindex, it denotes unlevered situations
E as sub or supraindex, it denotes variables referred to the entrepreneur or the owner of
a firm
F Represents the firm’s self-generated cash flow in terms of the net operating income
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before interest and taxes

D denotes the nominal value of the outstanding debt
T Represents the rate of imposition for the tax on the firm’s incomes

In particular
rf risk free interest rate
rD interest rate to be perceived upon the private debt contracts, equal or nearby rf
rU interest rate which bears with the economic risk of a business, pointing out the
opportunity cost for that activity
rE interest rate representing the opportunity cost of the levered owned capital thus,
adding to rU the cost of the entrepreneur’s financial risk
V market value for the whole financial assets of a levered firm, that is to say, the financial
value of the owned capital plus debt
VU market value of a non-indebted firm, hence of the unlevered owned capital
E
V market value of the owned capital financially levered
VD=D market value of debt which, under the conditions stated for the analysis, it always
equals the nominal value of the outstanding debt D

3. Self-generated incomes distribution and the firm’s value

When we take into account the presence of the income tax over the benefits of a financially
levered firm, the net operating income F self-generated by such a firm is distributed among three kinds
of inflows:
1. The one which goes to the lenders to pay the interests over debt, FD, denoting incomes of private
appropriation (16).
G
2. The revenues perceived by Government as the tax on incomes, F , which represents funds of
public appropriation. (For simplicity we assume it is determined applying a unique proportional tax
rate “t”).
E
3. Finally that of the entrepreneur, F , who receives the residual flow also as a private subject.
In accordance with our assumptions these inflows give rise to three types of cash flows along
time, each of which is built subject to the following scheme:

Cash Flows

Firm’s Net Operating Income F Firm’s c.f.

Interest payments - rD.D= -FD Lender’s c.f.
Benefits Before Taxes F-rD.D
Taxes - t(F-rD.D)= -FG Government’s c.f.
Benefits After Interest and Taxes (F-rD.D)(1-t)= FE Entrepreneur’s c.f.

Owing to the fact that interests on debt are deductible for determining the income tax, the
lenders have collection precedence over the Government. A growing debt increases interest payments
too, thus, the public appropriation income is reduced in favor of private ones. Therefore, the financial
leverage seems to raise private inflows exactly in the same amount the public revenues are reduced,
and it is in this sense that in their 1958 paper, M&M acknowledged debt introduces an increase of
benefits. In fact, laying aside any consideration on the income tax to be paid in turn by the lenders, the
E D
addition F +F =F(1-t)+t.rD.D is the remaining cash flow of shareholders and lenders while, without
debt, the private income would be reduced to F(1-t). On the other hand, if we assume that the lenders
also pay a rate “t” of taxes over their incomes, when deducting the amount “t.rD.D” from the private
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inflow, the latter turns out to be the same as without debt. However, leverage does not result in altering
the benefits expected from the economic activity; likewise, by adding the three cash flows previously
D G E
described, we can verify they always totalize the net operating income, F= F +F +F .
For an entrepreneur financing his o her activity entirely with owned capital, the residual cash
flow would be the net operating income after taxes, F(1-t), that we symbolize as FEU. Hence, the
subtraction FE-FEU shows us the incomes difference between the indebted entrepreneur and the one
which is not,
FE = (F-rD.D)(1-t)
EU
-F = - F(1-t)
FE-FEU = -rD.D+t.rD.D

We can see that, with debt, the shareholder’s income is reduced by the amount of the interest
payments but it is increased in the amount of the tax shield provided by debt. As a consequence, if
there is a levered increase on private incomes, it goes to the shareholders’ hands. Notwithstanding
this last effect represents an advantage, the net residual income obtained with leverage becomes
smaller than without it because, as it is 0<t<1 it means that in absolute terms it is rD.D>t.rD.D so, being
FE<FEU. But, does the tax shield represent an advantage or it is an equitableness matter? That is to
say if both, the firm and the lender are taxable subjects, we plainly need to deduct from the former the
amount of taxes to be supported by the latter.
In accordance with Modigliani and Miller, the greater private incomes provided by the financial
leverage must derive in a greater value for the financial assets representing the claims over the firm.
The value of this private increment equals the present value of the additional cash flow provided by the
17
debt tax shield, discounted at the same rate rD ( ) that is collected for interests. As a consequence,
the value of the levered firm is,
F (1 ϑ t ) t . rD . D
VΖ Η Ζ V U Η t. D [11]
rU rD

We should note that at [11] the valuation is made attending to the probability of the tax shield to
be obtained, which is the same certainty we have on the fact that the obligations will be paid. This
procedure evidences the value difference between the whole financial assets of the levered firm V,
u
and those of the non-indebted firm, V . However, we have also seen the tax shield as forming part of
the shareholders’ inflow and so, it will be discounted accordingly to the opportunity cost of the owned
capital rE. This entails no contradiction, because it just means that the tax shield, if used, bears the
same risk than the entrepreneur’s earnings. For this reason, and always in accordance with the
Proposition I of M&M, it is:
( F ϑ rD . D)(1 ϑ t ) rD . D
V V E Η D Ζ Η [12]
rE rD

As the opportunity cost over the owned capital rE agrees with the Proposition II of M&M, and
the tax over the lender’s incomes is not taken into consideration, the Weighted Average Capital Cost
WACC for the firm is the one which stems from the Proposition III in a world with taxes. Consequently,
with the latter we have that
F (1 ϑ t )
VΖ [13]
WACC

[13] means that the benefit of increasing the private income derived from debt is equivalent to
discounting the unlevered firm’s cash flow, with a capital cost below the rate rU , so that this same
stream of benefits provides a greater value, identical to that obtained by the levered firm. We can
reach the same conclusion regarding the capitalization from the whole investment in real assets I, but
we must first observe that, disregarding debt interests but considering taxes, the return IRRU is:
 10

F (1 ϑ t )
IRRU Ζ [14]
I

In turn, the Net Capitalization Rate is obtained as the association of this internal return with the
Weighted Average Capital Cost, so that:
IRRU ϑ WACC
NCR Ζ [15]
WACC

Hence, the capitalization rate defined in [15] also verifies that:

V  V E Η D Ζ I (1 Η NCR) [16]

We should note here that, given a smaller average cost of capital than the one pertinent to the
risk of the activity -WACC<rU-, the capitalization rate of the levered firm is greater, since the leverage
will increase the relative difference with respect to its internal return. In other words:
IRRU ϑ WACC IRRU ϑ rU
[  NCR [ NCRU
WACC rU

Despite the formal validity of this analytical framework, its relevance lies on how we define the
tax burden on the lender’s income and, in turn, its impact over the cost and value of debt. For
example, we can assume a scenario offsetting the benefit of the tax shield for the private agents, when
the whole private incomes derived from a levered situation become the same as if without debt. If we
assume the lender’s incomes are taxed with the same rate “t” as the firm’s residual benefits, the self-
generated inflows going to private hands would be
( F ϑ rD .D )(1 ϑ t ) Η rD .D (1 ϑ t ) Ζ F (1 ϑ t )
Thus, we would find the same than in an unleveraged situation, and the relevant cost of capital for the
firm may be again the rate rU which bears the risk of the activity and not the WACC. It is worth relating
the “tax shield” not only to benefits but to a matter of equity as well, so as to deduct from the borrowers
the very tax amount to be paid by the lenders. Besides, what we intend to highlight, is that this kind of
analysis focuses on an indirect and inaccurate way to determine the convenience of leverage, as well
as its benefit for the entrepreneur or risk taker.
As the value of debt derives from a money agreement, the benefit meeting the lender’s
expectations are solved in advance, through the debt contract. Hence, for the purpose of business
evaluation and its financing, it seems more realistic to rely directly on the analysis of the effect of debt
over the results for the entrepreneur. Therefore, we need to attend to the equities’ value as arising
from the capitalization of the expected residual benefits with respect to the capital contributed by the
E
entrepreneur to carry out an investment project, or to create a firm. But, in order to determine V as a
function of the capitalization rate, it will be convenient, to priory review the behavior of the cost of the
owned capital against the financial leverage.

4. The certainty equivalent and the cost of the owned capital

We have referred to the net operating income as an average amount with a certain expected
variance by which we anticipate that, in practice, F will verify biases to the mean it represents. This
reason -the risk of perceiving a lesser amount than the expected one- is what in turn supports
discounting the self-generated inflows with a rate of interest bearing the cost of that risk. However,
according to the literature on the subject, instead of adding a risk premium or over-rate to the “inter-
temporal” cost of money, we can estimate the latter in terms of the “certainty equivalent” of an amount
of money; in short: determining how much money represents a future but certain inflow, as to be
discounted at a risk-free rate in order to get at present the same amount as for the expected risky
 11

income. Thus, the differential between both prospective amounts is taken as a measure of the
magnitude which we expect not to perceive, and which will be deducted as the risk cost.
In virtue of the risk inherent to an economic activity, implicit in the rU rate, the present value of
the self-generated incomes F denotes the “reproduction value” of the whole future money that the firm
will generate. We symbolize this amount as VA, to state the financial value of the whole net operating
incomes expected along time, also including the payoffs to the Government sector. This is, therefore,
the same value that the firm would have in a world without taxes,
F
VA Ζ [17]
rU

The certainty equivalent of F here will be symbolized as S , and can be obtained as the
A 18
product between V and the risk free rate rf ( ) verifying that,
S
VA Ζ [18]
rf

This form of estimation for the certainty equivalent provides an average value, similar to the
procedure applied to find constant annuities for a cash flow with non-constant inflows between periods,
19
by means of the Capital Recoupment Factor ( ). Now, equaling the right sides of [17] and [18], we can
clear that:
rf
SΖF [19]
rU

With [19] we verify that, as it is rf<rU, its quotient is smaller than the unit, and consequently, it is
also S Ψ F . In turn, the difference F ϑ S is the amount to be deducted from F as the cost of risk or, in
other words, the uncertain, non-verifiable amount expected from future incomes.
If we consider that, as a necessary condition for the absence of any default risk, the debtor
must not assume obligations beyond his or her certain capacity to self-generate incomes, the money
to be paid as interests over debt must not exceed the amount of the certainty equivalent of the firm’s
expected incomes. This means that it is required to be
rD F
rD . D  S  rD . D  F  D [20]
rU rU

The last inequality at [20] requires the outstanding debt not to exceed the firm’s reproduction
value, in a world without taxes. In other words, the debt must not exceed the financial value of the
stream of benefits before interest and taxes, in a world with taxes. In an extreme situation, we would
have a debt amount representing this relation: rU.D=F . In the terms defined by the M&M Model’s
relationships, for a levered firm under the presence of taxes, under this situation we should get the
maximum value for such a firm, as in:
F
t . rD
F (1 ϑ t ) F (1 ϑ t ) rU F
VΖ Η t. D Ζ Η Ζ [21]
rU rU rD rU
Considering taxes, and assuming that the debt will be repaid, the firm’s value would be the
same as that in a world without taxes. This would happen when the whole certainty equivalent of the
self-generated incomes were applied to meet the debt commitments, because the debt payments has
20
collection precedence over taxes( ). Anyway, this does not seem a reasonable limit to pursuit, as we
will see later, when considering the conditions for a “normal” debt, because –among other reasons-
 12

from the entrepreneur’s point of view, getting a tax shield which he or she does not expect to use
seems pointless, since it would vanish the “benefit”.
Under a levered situation, we considered in turn that the owned money invested bears the
financial risk derived from an increased expected variability over the remaining incomes going to the
entrepreneur’s hands. This reflects the fact that the payoffs stated at the debt schedule are deducted
from the certainty equivalent of the firm’s cash flow and, as a consequence, the same uncertain
amount expected from operating incomes, F ϑ S , shares a greater proportion over the diminished
residual, as the shareholders increase their leverage.
This fact actually suggests a way to deduce the opportunity cost for the owned capital, the rE rate. To
E
do this, we define the residual certainty equivalent of the shareholders as S , the difference between
the firm’s “certainty” cash flow minus the payoffs for the interest on debts:
E
S Ζ S ϑ rD . D [22]

Now, supposing that a risk-free debt pays the risk-free rate, rD=rf, and substituting S at the last
expression with the right side of [19], we get:
E rD
S ΖF ϑ rD . D [23]
rU

Under the existence of the income tax with deductible interests on debt, we must redefine the
E
entrepreneur’s income, in order to obtain his or her residual certainty equivalent, net from f taxes, S T ,
E  r 
S T Ζ  F D ϑ rD . D (1 ϑ t ) [24]
 rU 

As the right side of [24] denotes the remaining certainty equivalent cash flow of the levered
entrepreneur, the value of his or her equities must be the present value of those incomes discounted
with the risk free rate:
E
E S T F ϑ rU . D
V Ζ Ζ (1 ϑ t ) [25]
rD rU

On the other hand, we know that, determined as a function of the amount F of the expected net
operating incomes and of the levered owned capital’s opportunity cost rE , the equities value stems
from the expression:
F ϑ rD . D
VE Ζ (1 ϑ t ) [26]
rE

As a consequence, when equaling the right sides of [25] and [26], we can clear away that:
F ϑ rD . D
rE Ζ rU [27]
F ϑ rU . D

As regards the meaning of [27], it verifies that:

 without debt, the cost of the owned capital is identical to the opportunity cost which only bears the
economic risk derived from the activity.
 changes in the tax rate do not affect the cost of the owned capital, and;
 under the presence of debt, and as it increases, rE rises as a function of the financial risk introduced
by the leverage.
The behavior pointed out in the last paragraph is confirmed when we derive [27] with respect to
the debt D, always assuming rU>rD,
 13

⌡ . rE F (rU ϑ rD )
Ζ rU [28]
⌡. D ( F ϑ rU . D) 2

It is worth noting that [27] is an implicit expression in the relationships commonly depicted by
the M&M Model. Hence, (27) verifies the same results as those derived from the Proposition II. In
accordance with this model, if we know rU, rD, F, D and t, in order to clear away the values of rE and of
E
V , we can build the following system of equations:
 D
rE Ζ rU Η ( rU ϑ rD ) V E (1 ϑ t )
 [29]
rE Ζ F ϑ rD . D (1 ϑ t )
 VE

Equaling the right sides of both equations stated at [29], we arrive at:
F ϑ rU . D
VE Ζ (1 ϑ t ) [30]
rU
E
Now, replacing V with the right side of [30] into the right side of the second equation of [29],
and operating, again we will arrive at the expression [27].
The line of the argument followed at this stage of the analysis first led us to switch the cost of
risk from the denominator of a valuation formula to its numerator. For that matter, the risk premium
over-rate rU-rf was replaced by deducting the cost of risk directly from the expected incomes.
Particularly, when paying attention to the behavior of the cost of the levered owned capital, at [25] we
found two alternative ways for valuating equities,
1. Strictly speaking in the terms of the entrepreneur’s residual certainty equivalent, the result stems
from applying the risk free rate.
E
2. Instead, when replacing S T with the right side of [24], we got an expression sharing the cost of risk
among numerator and denominator.
About the second above mentioned alternative, the financial risk introduced by leverage derives from
decisions which are endogenous to the entrepreneur, and their cost was shifted from the denominator
to the numerator by weighting debt in concordance with the risk of the activity as borne by rU. This last
rate in turn, also remains at the denominator -instead of the opportunity cost for the owned money rE-
keeping therein such a kind of risks involving exogenous causalities. But, with respect to the first
alternative, is it possible at all to eliminate the risk cost at the denominator? Although so is suggested,
we need to realize that changes at the risk free rate of interest are also a risky matter exogenous to
any particular business. In itself, the concept of the certainty equivalent is a function of the risk-free
21
rate( ).

5. The NCR as an efficiency indicator of the owned money invested

The words “entrepreneur” and “shareholder” are sometimes vaguely used in reference to who
participates at risk on businesses’ benefits. For our further analysis, instead, it will be necessary to
differentiate the meaning for each one of both terms. As “entrepreneur” we define the person who,
also being a shareholder, directly takes part in the adoption of the firm’s policy as in its conduction and
management. The entrepreneur’s level of engagement is understood as greater than that of the only-
shareholder, because the first represents the firm and has a direct responsibility for its performance.
His or her acquisition of equities is not decided from the point of view of a financial investor composing
a securities portfolio, but from the one who shares the condition of an owner in a way to support the
business’s risk as an “economic operator” of the firm. On the other hand, we will identify as a “pure
shareholder” at the one who also provides money to afford a business, but limited to be a financial
 14

investor and/or operator. His or her role in the management and decision making of the firm is, at
most, exercised throughout the selection process of its management and control committees.
While by his or her business decision the entrepreneur will capture the differential between the
financial value of the future benefits and the cost of the investment, the pure shareholder only gathers
the return pertinent at the financial market. This is what explains the capitalization to be gained by the
entrepreneur over an additional investment wholly paid by third party financing, coming this from
lenders or from “partners” subscribing an equities’ new issue. To this last respect we should note that
the former or “senior” shareholders, although some of them acting as merely financial investors, will
also share the same capitalization gains of the entrepreneur due to the new investment. We will prove
these concepts when analyzing the future benefits capitalization focusing on the Net Worth.
For a project, a greater return than the cost of money is required as an acceptability condition
to obtain a positive NPV, what also means an IRR exceeding the return demanded by the financial
market. Hence and in so far as we can buy present money paying for it its market cost, financing will
leave an additional remnant over the money invested. This remnant comes from the relative difference
between the internal return of the project and the opportunity cost of the purchased money. It is at this
kind of operation, made through the sale of equities or bonds, where the financial investor takes
participation composing a portfolio according to his or her subjective preferences about risk. When an
ongoing firm publicly subscribes equities to finance a project, the new partners will share benefits in
the proportion their capital have with respect to the value of the whole equities and not with respect to
the value of the whole real assets. At market, equities will be paid in concordance with the financial
return required over the expected inflows, thus the relative difference with the project’s return will
remain in favor of the previous shareholders through their equities’ revaluation.
With respect to the third party money, its cost differs between the two main financial sources
that we are considering now, that of the lender who claims certainty over the commitments and that of
the shareholders accepting bearing risk over their expected inflows. For this reason in the last case,
the return rE required on equities is a cost in direct association with the risk that the economic activity
supports but, also, with the financial risk introduced by leverage over the residual inflows for the
shareholders.
As long as the entrepreneur gets into debt, his o her expectable incomes is reduced but,
furthermore, those incomes are discounted with a greater interest rate, and both effects from leverage
concurrently diminish the equities value. Hence it is in this way that, to determine if the situation of the
entrepreneur improves or gets worse, a criterion to apply is to measure the efficiency obtained over
the owned capital invested. This fact will let us to observe the “financial” effect from leverage, instead
of the “redistributive” one, starting by associating the equities’ market value with the Net Worth. In
order to analyze the desirability of financing with respect to the efficiency of the owned money invested
we will work assuming that rE performs with the linearity pointed out by Modigliani and Miller, but using
its transformed version denoted at [27] as a function of the certainty equivalent of an amount of
money. As an example, we initially imagine a project which gives rise to the creation of a new firm.
With I we will denote the total amount invested in real or fixed assets and for the debt D we will
adopt as a restriction that it will always be less than the investment, D<I. Then, accordingly to the
E
definition of the Net Worth, we will represent our owned capital in terms of real assets with I , such
that it is
I E Ζ NW Ζ I ϑ D [31]

With leverage, we transform the entrepreneur’s cash flow but, also, the Net Worth defined as
his or her owned capital contribution. Hence, the return to get with the residual incomes differs from
such of the project due to the incidence of both factors. Under these conditions we will distinguish the
internal return obtained with an “E” as subindex,
( F ϑ rD . D)(1 ϑ t )
IE Ζ [32]
IRRE
( F ϑ rD . D)(1 ϑ t )
IRRE Ζ [32]bis
IϑD
 15

The expression [32]bis points out the return after interest and taxes over the Net Worth, a ratio
or rate which we also know as the “Return On Equity” or ROE. According to this rate, the valuation of
the residual incomes equals the value of the owned capital invested as stated in [32], whereas their
market value relies on the rE rate effectively adopted by the market to discount such incomes,
( F ϑ rD . D)(1 ϑ t )
VE Ζ [33]
rE
E E
Given the amount of present money invested I and the present value V of the future money of
equities, the capitalization rate has the same algorithm we saw in [1] to denote the relative difference
between the values of the financial and the real Worth. So, the pertinent concepts now applied as it is
derived from [32] and [33] are, for an entrepreneur financially levered, are
V E ϑ I E IRRE ϑ rE
NCR E Ζ Ζ [34]
IE rE
E U
We know that, without debts, it is rE=rU and V =V =F(1-t)/rU, and as a consequence, the
E U
capitalization rate of the project and that of the entrepreneur would be the same, NCR =NCR .
Instead, and yet without taxes assuming t=0, we verify that financing alters the entrepreneur’s
capitalization. With obligations but without taxes on earnings, it is IRREIRRU and rErU, the
internal return as well as the entrepreneur’s opportunity cost differ from those of the project
E U
which, in turn, also causes the respective capitalization rates NCR NCR to be different. As a
consequence, the financial leverage affects to the efficiency of the owned money provided by
the entrepreneur regardless the tax presence.
We have just proved how leverage impacts on the entrepreneur’s net capital gain to get from a
project by means of the surplus value of the financial assets over that of the real ones. If the market
acknowledges a good investment decision as operators on the real sector of the economy, we can
expect to perceive the benefits to be derived from the project along time or, alternatively, to obtain the
profit at present by selling our financial assets. The Net Capitalization Rate shows the rate of the
capital gain over each dollar of the owned capital invested while, in turn, the third’s party financing has
incidence on the capitalization to accomplish and, therefore, over the efficiency of the owned money
contributed for the business.

To have a formal association to analyze the behavior of the capitalization rate as a function of
E
debt, we require to build an alternative equation for NCR . For this purpose, at [34] we replace the
term IRRE by its expression accordingly to [32]bis, thus clearing away,
( F ϑ rD . D)(1 ϑ t )
NCR E Ζ ϑ1 [35]
rE ( I ϑ D)
E
Although [35] links the value of NCR with leverage, we have the rate rE as an argument which,
in turn, also depends on debt. For this reason at the last expression we replace rE with the right side of
[27] and, operating, now we can clear away the Net Capitalization Rate as a function of the certainty
equivalent, NCRSE ,
( F ϑ rU . D)(1 ϑ t )
NCRSE Ζ ϑ1 [36]
rU ( I ϑ D)

With [36] we see that, as long as the dominion of the function is limited to values such to be
debt minor than the investment in real assets, D<I, and with positive interest rates, the numerator of
the first term of the right side it is required to be greater than the denominator to get a positive value
E
for TCNS . This means that the capitalization will be positive whenever the entrepreneur’s expected
 16

incomes (numerator) surpass the return demanded on his or her owned contribution I-D
(denominator). In other words, we require (F-rU.D)(1-t)>rU(I-D).
Upon deriving [36] with respect to the debt we obtain,
⌡ . NCRSE ( F ϑ rU . I )(1 ϑ t )
Ζ [37]
⌡. D rU ( I ϑ D) 2

This expression shows , unequivocally, that the capitalization rate rises with debt whenever the
stream of net operating incomes F surpasses the product of the economic cost of money rU by the
whole amount invested I. Under the case of an equal value for both factors, it would be a project with
NPV=0 and the growth of the capitalization rate(22) would also be 0. The situation with F<rU.I is not
relevant because it implies that we would be accepting a project with a negative NPV or, what is the
same, with IRRU<rU.
Deriving again [37] with respect to the debt, it is
⌡ .2 NCRSE ( F ϑ rU I )
2
Ζ 2rU 2 (1 ϑ t ) [38]
⌡. D rU ( I ϑ D) 3
and we also verify that the capitalization increases at a growing pace in a direct relationship with the
debt level, as long as F>rU.I and D<I.
The function at [37] brings us an answer about which is the benefit of the financial leverage for
the entrepreneur, beyond to perceive the tax shield under the presence of taxes: the debt introduces
an increasing efficiency for the owned capital invested, measured it as the rate of capitalization over
E
the Net Worth in real assets. Accordingly to [31], I , NW and I-D are indistinct representations of the
E E
same concept. Hence, when replacing NCR at [34] with the right side of [35] and operating to clear V
we can obtain that
 ( F ϑ rD . D)(1 ϑ t ) 
V E Ζ NW   [39]
 rE ( I ϑ D) 

The quotient of the right side of [39] indicates the entrepreneur’s Gross Capitalization Rate,
E 23
GCR ( ). Then, as an abridged expression we can write,
V E Ζ NW . GCR E Ζ NW (1 Η NCR E ) [40]

E
The product between NCR and the Net Worth is the incremental of the financial Worth over
the real one. This is the capital gain, or NPV from the project, to perceive in terms of the financial
solution adopted to carry out the project.
A simpler visualization of the already seen relationships is obtained when rE is cleared away
from [39],
NW ( F ϑ rD . D)(1 ϑ t )
rE Ζ [41]
VE IϑD

The second quotient of this last equation is the IRRE we saw with [32]bis which, in
concordance with our assumptions, it has correspondence with the ROE of the owned levered capital,
so
NW NW
rE Ζ E
IRRE Ζ E ROE [42]
V V

The acceptability condition for a project is a positive NPV. This condition, applied to the
entrepreneur’s levered results, requires the value of his equities to exceed the value of his NW. In
E
other words, V >NW. Under this last condition the first quotient of [41] is smaller than the unit, thus
verifying: rE<IRRE. In addition, ,when replacing ROE at [42] with the right side of 32[bis], the terms
 17

NW and I-D can be eliminated, as they mean the same at numerator and denominator. So, rE is
denoted by an earnings-price ratio.
The conclusions obtained do not contradict the criterion of maximizing the whole private value
for the firm as an indirect solution to improve the results of the owned capital. In the terms of the
M&M’s Proposition I we have that
V  V E Η D Ζ I E (1 Η NCR E ) Η D [43]
with
( F ϑ rD . D)(1 ϑ t )
VE Ζ Ζ I E (1 Η NCR E ) [44]
rE

Plainly, what we have got is a direct way to evaluate the best alternative for the entrepreneur.
Whenever we can assume the outstanding debt will equal its market value, the level of debt will not
represent a relevant concern for the lender, because there would be no risk in it. As a consequence,
from the entrepreneur’s angle the most desirable value for the firm stands at the point at which debt
offers him or her the greater efficiency (capitalization rate) over the owned money invested. In fact,
this can be solved with regard to that efficiency under normal debt conditions. Although we have just
verified the NCR as an increasingly function in direct relationship with the amount of debt, it will be
useful to confirm the levered capitalization is higher than the unlevered one. Given the capitalization of
the owned levered capital,
( F ϑ rU . D)(1 ϑ t )
NCRSE Ζ ϑ1
rU ( I ϑ D)
and the capitalization to get without debts,
F (1 ϑ t )
NCRU Ζ ϑ1
rU . I
the foregoing verify that it is
D( F ϑ rU . I )
NCRSE ϑ NCRU Ζ (1 ϑ t ) [45]
rU ( I 2 ϑ I . D)

We have noticed that for a profitable project it must be F>rU.I, as to get a positive numerator at
[45]. On the other hand, it was assumed that the investment was greater than the debt. This fact
determines that I2>I.D, and thus, the denominator will also be positive. Hence with a positive
E U
result, the expression [45] means NCRS >NCR . Thus, under normal debt conditions, the
capitalization rate -or efficiency- over the owned money invested is higher under a financially levered
situation.

6. Limits to the normal debt

The certainty equivalent led us to identify a possible limit for the repayment capacity of debt
under “normal” conditions. That limit is the amount of the self-generated incomes we expect to
perceive, with considerable degree of certainty, as it is suggested by the prices assigned by the
market to future money. Thereinafter, with [36] we obtained an expression for the Net Capitalization
Rate as a function of the certainty equivalent which takes up the same restriction at its numerator.
Besides, its denominator demands that the investment be greater than the debt.
The condition I>D may seem a trivial one for the case when a new firm is constituted. In fact, it
doesn’t look rational to suppose that anyone will lend an amount of money equal or greater than the
value of the real assets required for the business. A project with a profitability greater than that of the
market, IRRU>rU; implies it must be F>rU.I Although this condition may point out a repayment limit for
∫rU.D>rU.I, to lend such amount would mean D∫
debt as stated by the inequalities F∫ ∫I and so, to accept
entrepreneurs risking nothing and lenders bearing the whole business’ risk in return for a risk free rate.
 18

However, this limit can be unnoticed in case of an already ongoing firm, due to the possible
discrepancies between the assets’ book value and its effective reposition market value.
To further the last comments, we need to note that the relationship between the real assets’
value and that of debt becomes important from the point of view of hedging the debtor’s moral risk,
24
risk already considered by John M. Keynes ( ) in 1936. The execution of the debtor’s real worth,
though a last instance proceeding for an adverse circumstance, is understood to be a factor capable
of limiting the moral risk (25). It is worth stating that the very instance of arriving at an execution stage
is an indicator of bad financial businesses and negotiations. In this sense and concerning the coverage
of debt with the firm’s assets, we should also take into account another two matters:
 the additional costs commonly borne at any execution stage;
 the variability of the assets’ market value.
The last arguments advocate for an amount of debt reasonably smaller than that of the investment, so
as to be able to cover those additional aspects, if we want to think in the terms of the absence of risk.
E
To summarize, with the function [36] of NCRS two possible limits are outlined to qualify debt as
“normal”. They are:
1. A limit to the operating capacity to repay the debt, or “repayment limit”, in terms of which the
creditor hedges the hazard or adversity risk in the debtor’s business. To accomplish this, the
amount of debt must not surpass the debtor’s expected self-generated income, discounted
accordingly to the risk of the activity performed:
F
D or rU . D  F
rU

2. A limit to the coverage capacity for debt, or “coverage limit”, in terms of the real assets belonging
to the firm. This defines a border line to the possibility of recovering loans under extreme conditions
of adversity but, above all, it supplies the creditor with some degree of restricting power in the event
of tricks aimed at altering the word of contracts, thus also supplying him with some degree of
coverage of the moral risk.
We must notice that, given a new profitable firm, it would not be possible to transpose the
repayment limit without first having transposed the coverage limit, as the firm’s return must exceed the
one demanded by the market for that activity. However, in the case of an already operating firm, it is
easier to assume conditions leading to trespass the second limit.

7. Financing and investment

As financing does not impact on the activity’s economic results, the investment decisions and
financing decisions can be treated separately. But, with regard to the efficiency the entrepreneur of a
project will get over the owned money invested, financing decisions are not irrelevant and also depend
on the outlined project. Obviously, the characteristics of the analysis will differ when applied to the
creation of a new firm or to the new project of an ongoing firm.
In order to study the link between financing and investment we will first analyze the
entrepreneur’s capitalization, limiting ourselves to those aspects we can think of as being endogenous
to his o her decisions. To observe the capitalization behavior, the variables to watch will be the
investment, the debt and the project’s self-generated inflows. Finding the partial derivatives of the [36]
E
expression of NCRS with respect to the three above mentioned variables, we get the following total
differential for the capitalization rates, the net or the gross one:
( F ϑ ru . I )(1 ϑ t ) ( F ϑ rU . D)(1 ϑ t ) 1ϑ t
dGCRSE Ζ dNCRSE Ζ 2
dD ϑ 2
dI Η dF [46]
rU ( I ϑ D) rU ( I ϑ D) rU ( I ϑ D)

A project defines a certain incremental investment dI in association with an increase of the

expected incomes dF. If these values are solved as a function of the investment decision, from the
 19

angle of financing we must still define the necessary additional debt in order to get a certain
capitalization rate. Alternatively, if we intend to keep a given rate of capitalization, we need to equal
E E
the total differential depicted by [46] to zero, dGCR =dNCR =0, and to operate so as to clear away the
differential dD satisfying with that condition,
F ϑ rU . D IϑD
dD Ζ dI ϑ dF [47]
F ϑ rU . I F ϑ rU . I

By [46] and [47] we verify that the efficiency (capitalization rate) to get over the owned money
invested, given an investment project, can be solved by means of an explicit analytical treatment of the
debt level associated with the expected inflows related to the amount of that investment.
The approach to solve leverage concerning the whole market financial value of the firm, leads
D*
us to look for a target ratio between the values of debt and equities, , with respect to which we
VE*
can assume to get a minimum Weighted Average Capital Cost, WACC. If we consider that a firm met
its optimum level of debt, in order to find the financial solution when a new project is being
accomplished, as for to keep debt within that target ratio, it is necessary to increase debt in the same
αF
proportion in which net operating incomes will increase. That is to say, with αD Ζ D we will
F
D*
continue satisfying once the project has been implemented. Notwithstanding, we can say
VE*
nothing with respect to whether the efficiency of the owned capital supplied is improved or not, nor
about the extent to which the target can be reached under the terms for a normal debt. The reason for
both facts is simply that the value to afford in the real assets required to self-generate the future
stream of inflows, has not been incorporated as an explicit analytical argument within the model’s
functions.

8. Debt or equities subscription?

Financing can be considered as desirable or as a necessary matter, depending on whether we

use it merely to increase the efficiency of our contribution to a project, or because we lack the money
to pay for the whole investment. Whatever the reason, for our purpose, will define the financing
demand “FD” as the difference between the investment cost “I” and the capital “Ko” provided by the
owners of a firm, so with FD=I-Ko>0. For the present analysis we will consider two paradigmatic
financing sources: the case in which financing comes only through an equities’ public offer
subscription, or the case when it is only got by means of a debt emission (bonds). We will work upon a
special situation, an investment project which gives way to the creation of a new firm. In turn, this also
demands to stretch a special assumption: that this new firm effectively can access the capital market
to deal with the public offer of equities or bonds. Notwithstanding, the conclusions derived from the
following comparative analysis can easily be extended to span the investment accomplished by an
ongoing firm already indebted, or not, or to evaluate the effect of using both financing sources
simultaneously. The expressions depicted at [46] and [47], in turn, are useful to further the analysis of
how consequences of financing affect the entrepreneur’s results.

A) Subscription of Equities
To analyze the third party’s money “acquisition” by means of an equities subscription we need to
differentiate between,
 the equities of the entrepreneurs of the project “Ve”, that is to say, belonging to those
shareholders who are the very founders of the firm, because they have supplied the amount Ko
as a part of the whole investment required; and
 20

 the new equities “Vf”, to be sold to the financial investors who will supply the financing demand at
the market.
As the firm will former no obligations, the value “VU” of the whole equities and its distribution
between the elder (entrepreneurs) and the new shareholders complies with the following
Ve V f
relationships V U Ζ Ve Η V f  1 Ζ Η
VU VU
In turn, the equities’ public offer is strictly made to collect the amount of financing demanded to pay
for the project such that, in terms of Vf=FD, we have
V U ϑ Ve Ζ I ϑ Ko Ζ V f
because the number of equities needed to gather the amount Vf is sold for its value as a financial
asset or, in other words, at the present value of the future money expected to be self-generated by
this project. Thus, rearranging terms at the relationships above stated we deduce that
Ve Ζ V U ϑ I Η Ko Ζ I (1 Η NCRU ) ϑ I Η Ko
Ve ϑ Ko Ζ ( Ko Η V f ) NCRU [48]
The left side of the last equation shows the capital gain, or entrepreneurs’ NPV, that is to say, the
differential between their owned equities value minus their owned present money provided to afford
the budget in real assets. The right side, in turn, explains that financial benefit as derived from the
product between the project’s Net Capitalization Rate and the present money supplied by the
entrepreneurs plus the financial investors. In other words, NCR multiplied by the whole investment
budget. As a consequence the new, pure shareholders, as retribution will strictly perceive the
opportunity cost of money, while the benefit from capitalization will be entirely perceived by the
entrepreneurs or former shareholders. Therefore, the entrepreneurs will capture the whole
capitalization benefit we commonly denote as the NPV of the project accordingly to its opportunity
cost rU. Thus, the former shareholders get the same capital profit they would have got, had they
paid for the whole investment with their own money but providing a lesser amount.

B) Debt Emission
Now we consider the financing demand will be solved through an emission of bonds, that is FD=D,
E
and the whole of the firm’s equities V will remain at hands of the entrepreneurs of the project. In
concordance with [16] the value of the firm with an unrisky debt will satisfy with the following
relationship,
V  V E Η D Ζ I (1 Η NCR)
where, from V E Η D Ζ ( Ko Η D)(1 Η NCR ) , we can clear away that it is,
V E ϑ Ko Ζ ( Ko Η D) NCR [49]
Again, the entrepreneurs’ benefit will be the product of the Net Capitalization Rate by the whole
amount of money invested in the project while, in terms of the present money provided, their
contribution amounts to I-D.

C) Comparison of Results
At A) we found that covering the financing demand with an equities’ subscription will produce as a
gain the whole project’s NPV and, in turn, the same happened with B) but denoting a different rate
to capitalize the investment. Subtracting between them both situations, and taking into account that
Vf=D=FD, we have
B )= V E ϑ Ko Ζ ( Ko Η FD) NCR
-
A)= Ve ϑ Ko Ζ ( Ko Η FD) NCRU
---------- -------------------------------
V E ϑ Ve Ζ ( Ko Η FD)( NCR ϑ NCRU )
 21

If debt in effect diminishes the average cost of capital for the firm, as we saw at the end of point 3,
U E
we would have NCR>NCR , hence with a positive result for the subtraction, V -Ve>0. But, if the tax
on the lender’s incomes offsets the reduction of the capital cost for the firm, it could derive in the
same capitalization rate for both situations, NCR=NCRU, thus being VE=Ve. Under this last
circumstance, an equities subscription or a debt emission would be indifferent alternatives from the
point of view of the entrepreneur’s capitalization. But, anyway, the value added to the owned money
supplied to afford the real assets is derived by paying for the third party’s money participation a
financial opportunity cost, which is less than the project’s return. As pointed out by the concept of
the Net Capitalization Rate initially described, it is the relative difference between the project’s
return and the cost of money what explains the gain to get when capitalizing the expected results of
the investment.

As a result of the analysis above developed we stress three kind of conclusions,

1. When the business’ results are shared in the proportion each partner contributes to afford the
investment spending in real assets it is obvious we cannot talk about financing, and the NPV of the
project will be shared also in such proportion among parties. As “financing” we understand those
cases in which the present money is obtained by paying its market opportunity cost for it and, in this
sense, financing cannot only be achieved through debt but also through any new financial
subscription of capital. Accordingly to the subjective preferences as a matter of a portfolio’s risk, a
financial investor can offer money at risk over the firm’s results or by means of money contracts as
loans assuring future return.
2. In practice it is rather difficult to suppose that a public offer of equities could be launched for a new
firm. However, a rational procedure could be to get indebted as a first step towards a subsequent
capital subscription opened to the financial investors. As this way may well enable us to retrieve the
owned money initially invested, we might also conceive a situation at which the original
entrepreneur keeps for himself the amount of the NPV invested at the firm while, simultaneously, he
or she recovers his or her initial investment capacity for other purposes. But, above all and for an
ongoing firm, this analysis shows how the whole investment can be paid by means of financing
through third party’s money, but retaining the NPV of the project for the entrepreneur and the
already existing shareholders.
3. When considering an indebtedness situation as depicted by B), from [49] we derive that,
V E Ζ Ko Η ( Ko Η D) NCR . However, if we apply the relationships depicted at [44] we also find it is
V E Ζ Ko (1 Η NCR E ) . Both ways of determining the value of equities satisfy with the M&M’s
Proposition I, because the expressions adopted for NCR complies also with the Proposition II. So,
equaling the right sides of the last two equations we have,
Ko Η ( Ko Η D) NCR Ζ Ko (1 Η NCR E ) [50]

This last equality stands since NCR<NCRE , where NCR is a function of WACC and NCRE is a
function of rE (that is to say, rU plus the financial risk introduced by debt). What matters about
these alternative expressions is that, as long as the “possibility of undoing leverage” is what
“prevents the value of levered firms from being consistently less than that of unlevered firms”(26),
we can solve the opportunity of financing by focusing directly on the situation of the entrepreneur
by means of NCRE. The target may be to maximize either the efficiency over the owned money to
invest, or to maximize the NPV to get.

9. Comments on the Answer

At their paper of 1958 Modigliani and Miller noticed that the strict equivalence between the
criteria of maximizing the flow of profits or maximizing Worth’s value, when evaluating a business, is
 22

only sustainable for a world with certainty. Facing uncertainty, instead, the only objective criterion
would be to attend at the market value of the financial assets, or Worth’s value, because the criteria of
maximizing benefits expose us to subjective expectancies for the valuation thereof.
However as Worth, a financial asset anyway synthesizes the subjective valuations of the
different agents intervening at the market, since its price denotes the present value granted for the
future incomes to be produced by the financial asset. This stresses the fact that the price of a financial
good, as an objective matter which defines its Worth value, depends on how much money it will be
providing and on the rate of interest which relates those future incomes with their price at present. On
this issue and with reference to our analysis, it is necessary to underline the differential characteristics
between the both kind of securities already considered.
A bond is a contract that commits to refund predetermined amounts of money along time. If
there are no adversity or moral risks upon the debtor’s capability to honor his or her commitments,
neither from adversity nor moral, there will not be discrepancies on which the future incomes to
perceive will be. That’s why the rate implicit in the bond’s price, which represents the discounted
present value of the future inflows, is taken as an indicator of the strictly inter-temporal cost of money.
On the other hand, an instrument at risk, like equities, does not involve any promise of a future
payoff. Dividends will be perceived if the firm has the residual incomes. As a consequence, to
determine the amount of those future incomes we must face the subjective expectations of any agent
regarding available information at the market. At the same time, the rate with which those expected
incomes will be discounted also implies subjective considerations on risk and expectancies. About this
matter, to focus on the investment’s effect over the financial value of a firm we must face a solution we
cannot implement if it is not just supposing any future income and the risk with which it will be
evaluated. Our equities will be priced by market at any circumstance, with or without a project, and our
challenge is to identify the expectations on risk and incomes to be synthesized by that price. This is to
say, how can we guess a value for our equities, or for the result of a project’s evaluation without those
elements?
With respect to the topics recently pointed out, one kind of problem is the methodology for
valuation and evaluation and a different one is to know in advance which values the relevant variables
will show at the market. About the methodology, maximizing the future benefits or the financial Worth
value are always equivalent criteria, as the value of a financial asset leans on the expected inflows and
the risk to discount them. But, the key variable to do this, is the correct identification of the owned
capital investment’s opportunity cost, accordingly to the risk of the activity and to the financial risk
becoming from leverage.
Returning to both types of securities we are taking into consideration, as alternatives to pay for
an investment budget and in accordance with the efficiency to be got over the owned capital
invested we found that,
I. As entrepreneurs, when using third party’s money we will get smaller inflows than those
self-generated by a project or a firm. The reason for it is that we will have to deduct the
financial cost of the part of the investment in real assets which we have not paid for, to
be timely returned to those who initially contributed to finance our new investment
budget. Notwithstanding this, we will retain the profitability of the project which exceeds
that of the financial market. This explains why we can grasp the whole project’s NPV
when, simultaneously, we are reducing our owned capital contribution, because we
retain for us the relative differential between the project’s return and the cost of money.
This is just the relevant effect of financing when getting money at its market cost.
II. With debt at a cost rD or with an equities subscription at cost rE, without taxes both
alternatives would bring the same benefit for the entrepreneur, which is to get the same
project’s NPV. With taxes it depends on whether in effect debt reduces the average
capital cost. To this respect we need to realize that, when obtaining money under the
form of equities paying for it a rate rE greater than rD, our owned equities in turn would
be valued with an rE rate smaller than if we had emitted debt. The strict compensation
for the results between both alternatives, equities or bonds, holds if rE has a linear
behavior with respect to the debt ratio, as stated at the M&M’s Proposition II.
 23

The concept of third party’s financing is a notion commonly associated with credit operations,
as we understand equities as a mean for the integration of a firm’s owned capital. Notwithstanding
this, with the relationships developed we also confirm equities subscriptions as another genuine way
for financing, to the extent it can give us the benefit of the net capitalization of a project’s future
expected results. That is to say, we understand financing as the obtention of third party’s money in
return for its financial cost. Concerning equities, this fact is verified when the capital obtained will share
profits accordingly to the proportion respect the whole equities value, and not with respect to the
amount to invest in real assets.
At the real world, in turn, we watch changing situations favoring, alternatively, the use of either
one of these instruments, or even both combined in a certain proportion. Aiming at answering this
fact, as a criterion to evaluate and solve the desirability of each of the financing sources, the owned
levered capital opportunity cost emerges as the meaningful variable to analyze because it enables us
27
to directly look for the benefit to be raised by the entrepreneur of a project( ). But we also need to
remind that this direct way for the analysis can be cleared out attending to the opportunity cost of
capital attributable as a function of the risk involved by a given economic activity, rU. For that matter,
and in as much as the financial solution for an investment falls within the limits observed for the normal
debt, we have verified the entrepreneur’s capitalization can be also determined as a function of the last
cost mentioned. This last fact is in line with the observations of Dixit and Pindyck (28), about that “Firms
invest in projects that are expected to yield a return in excess of a required, or ‘hurdle’, rate. Observers
of business practice find that such hurdle rates are typically three or four times the cost of [unrisky]
capital.”
Financing, consequently, has relevance from the point of view of also financial variables, as the
monetary return related to the owned money invested. This tells us about a redistribution of money as
a consequence of the undertaken risks and the entrepreneurship initiative. On the contrary, talking
about an economic scope, in particular debt is always irrelevant: the highest expectable private
incomes the debt could provide strictly compensate the lowest taxes which will be collected by the
public sector. The benefits from the project will be always the same with or without debt, and they
depend on the value added the project will produce as a trade off for the postponed present
consumption. What third’s party financing modifies is the distribution of the value added as a
retribution to the capital factor, accordingly to the modality by which it was supplied.
The limits to the normal debt we have already argued suggest as conclusion such concepts we
usually recognize as a matter of common sense:
 the capacity to afford the debt commitments is related with the presumably certain capacity of the
debtor to self-generate the necessary means of payment, and
 the restriction to the moral risk imposes to constrain debt to amounts lesser than the amount in
assets necessary to perform a given activity.
For example, we can think about the last point as rather naive because, as a principle, nobody
would lend more than the money required for a business, nor a lesser but nearby amount to perceive
as retribution only a risk free rate. Also when taking into account simple principles of the balance
sheet, as anytime the liabilities are greater than the assets a firm is bankrupt. Besides, we need to pay
attention to the fact that the left side reflects values pertaining to real and financial assets while, by
definition, the liabilities at the right side are always financial concepts. However, these matters seem
unclear in a doctrine which, on the one hand, forces us to identify the efficiency level of debt as the
point where its marginal benefit equals the marginal cost of the troubles arising from an increasing
debt, and which, on the other hand, ignores the real assets’ value supporting the value of the financial
assets representative of the business. To this last respect we find an enterprise is profitable, whenever
the present value of the future money it will provide is greater than the present money to invest for it.
This is exactly the plain meaning of the NPV when going beyond an abstract indicator of desirability or
merit.
With respect to the repayment capacity, once its limit is transposed the debt market value may
also follow a simple principle. Irrespective of its nominal amount, its worth will not exceed the present
value of the future money expected as certainty repayments. And the same may apply to the whole
financial assets of an economy, the worth of which should not surpass the economic activity supported
 24

with the real assets. We measure the economic activity in terms of “Product”, as the “present good
and services” added, or as the “present incomes” generated per unit of time. Instead, the “production
of financial goods”, representing monetary claims over “future products”, is not considered. In this
sense, as a non-inflationary monetary policy we aim to restrain money emission along with economic
growth. This fact pays attention to the present money available to people. But, how can we relate the
financial instruments issuance, as promises for future payments, with the expected economic
performance? These comments are oriented to look for a possible link between an over-indebted
private sector and the volatility of some markets, to the extent as fiscal instability and devaluationary
forces also well may appear to be related to the private over-indebtedness. In this respect we need to
note that the expected fiscal revenues to be provided by the tax on the firm’s and creditor’s incomes
bear, at least, the same risk than that being supported just by those taxable incomes. That is to say, a
context of companies with an increasingly high over-indebtedness situation, for some economies it
would mean an increasingly higher fiscal fragility. As a consequence, in turn, this fact may contribute
to add volatility at the domestic capital market. This situation may be reinforced anytime the over-
indebtedness was funded abroad, because of the tax revenues expected to get from the firm’s
economic activity can be preponderantly shifted to the lenders’ economies.
There is one additional consideration to do, referred to the capitalization concept we dealt with.
As measured for one period in the context of the Capital Asset Pricing Model, the “market
capitalization rate” MCR is determined deducting unity to the quotient between two successive prices
or market index values. Thus, formally, we have that
pt
MCR Ζ ϑ1
pt ϑ1

In turn and accordingly with our assumptions, if we also suppose the price p of a stock in an “i” period
denotes the present value of the dividends expected in that period for the following one Ei(NBi+1),
Ei ( NBi Η1 )
treated as a perpetuity, it is pi Ζ Hence, substituting the prices depicted in the expression
ri
above with the right side of the last equation, we have that
E i ( NBi Η1 ) ri
MCRi Ζ ϑ1 [51]
E i ϑ1 ( NBi ) ri ϑ1

This last expression shows that MCR behaves in a direct relationship with respect to changes
in the expected benefits and in an inversely one with respect to changes in the interest rate. When this
rate r is assumed as a constant, it can be demonstrated that the Net Capitalization Rate emerges as a
particular case of the Market Capitalization Rate, when the implementation of a new investment
increases the expected benefits to be perceived. Hence again, from the point of a business view, to
maximize profits or to maximize Worth are indistinct expressions for a same result. In addition to this
particular aspect, the function depicted at [51] points out how the market financial opportunity cost “r”
relates with the commonly observed capitalization at markets.
Besides here accounting for the addition of a new project, the term “NB” may well account for
changes in the expected earnings of a firm, due to the adoption of such measures as considered by
the Economic Value Added analysis, EVA(29). To this respect we need to note that, for a single period,
the economic value addition is determined as the product of the capital invested I and the difference
between the return on assets (ROA=IRR) minus the cost of capital (rU or WACC). Conceptually, for the
sake of simplicity, it is EVA=(IRR-r).I, where “IRR.I” depicts the future earnings and “r.I” the earnings
required to compensate the capital cost. Valuing the EVA’s inflows as a perpetuity, what we get again
EVA IRR ϑ r
is Ζ .I Ζ NPV . The EVA’s discounted value represents the NPV of the decisions
r r
adopted to improve earnings with respect to the invested capital, emerging as the product between the
NCR and the value of the required real assets.
 25

Sometimes we deal with rates as if they were another product from nature although they only
exist in our mind. Rates derive from the simplest financial model devised by our analogical thought: it
states a proportional relationship between a future payoff and its present value. The only objective
matter we know are the market prices of the financial goods, and this is precisely the circumstance
Modigliani and Miller have highlighted. Under certainty we can assume a unique cost for the
association of present and future money, the time to wait for it. But whenever we deal with
prospectives, we need to argue something else to explain the value of a financial asset. It is in this
sense that the findings of those authors get relevance regardless of the true rate to discount future
and risky money and of the subjective preferences for any particular methodology to apply to those
rates, arbitrage avoids a systematic risk premium over the value of the whole financial assets of a
levered firm. Once Proposition I holds, propositions II and III are necessary conditions, related to some
rate rU bearing with the activity’s risk cost.
The Arbitrage Pricing Theory, APT, based on the law of one price for identical items, shows us
how we can go from a multi-index model to an explanation of the market’s equilibrium. Those indices,
in turn, are what provide the link for the effects of the outstanding set of explanatory variables, such as
inflation, the term structure of interest rates, the risk-premia, the industrial production and so forth.
With respect to the CAPM, the APT provides us with an insight to distinguish between the endogenous
and exogenous factors of a firm, i.e., which support the firm’s market value. Notwithstanding this, “the
APT solution with a multiple factors appropriately priced is fully consistent with the Sharpe-Lintner-
30
Mossin form of the CAPM”( ).
As regards the above mentioned matter, the concept of NCR hints at how the two referred kind
of factors may operate through a standard model of valuation. In effect, its expression as a function of
the certainty equivalent shifts the main components of the endogenous factors to the numerator (in our
case due to the financial decisions). This was made restricting the cost of the exogenous risk to the
31
denominator( ). Perhaps, the APT approach may be an adequate tool for analyzing those expected
returns leaning on the economic performance, whereas their difference with the whole expected
return derived from a CAPM estimate for a given asset, could well be a way of testing the cost of those
factors endogenous to the firm’s business policy.
Uncertainty certainly may trouble and entangle our analogical mind. Is there an only way to
determine the effect of risk over the value of a financial asset? Uncertainty poses us before subjective
criteria as pointed out by M&M. So, is it relevant to use the same procedure to value any risky financial
commodity, as if everything in that financial commodity was a succession of unrisky credit claims? This
fact is so suggested with the adoption of the NPV valuation formula for both kind of assets, equities
and those derived from unrisky debt contracts. In addition to the fact that we can relate a future payoff
with its present price in the plain term of only a unique rate bearing some risk premium, we can
contrive different ways to explain the relationship prevailing between a same set of values, the present
and the expected future one.
The modelization developed in this paper led us to link the whole financial value of a firm, and
its capital cost, with the benefit derived for the entrepreneur from capitalizing his or her future
expected results. We also found a way to recognize some hints about the limits to the normal debt
through a rough analogical procedure that shifts the risk cost to the numerator of the valuating
formula, as a function of the riskfree interest rate. Beyond the fact that these limits are feasible to be
explicitly used in an analytical framework, it also allows to base the analysis on a single rate bearing
with the uncertainty cost attributable to the activity by the present expectations. This last fact is in line
32
with the “hurdle rate” pointed out by Dixit and Pindyck( ), though here applied following an orthodox
criterion aiming to evaluate an investment decision and its financing under a business scenario.
Hitherto, to interpret the differences underlying between the orthodox analysis and that adopting the
principles of the financial options valuation for investment decisions, again we need to differentiate
between two kind of investments.
On the one hand, we may characterize as “financial risk takers” to those persons investing in
financial assets to get the opportunity cost of money. Anytime the returns evolution don’t fulfil with
expectations, these investors easily can, although at the cost of some loss, restructure their portfolios
or even yet to exit from the initially selected investments. It is as inherent to the financial business to
 26

ease a long term yield based on a short run portfolio administration, a matter which makes the Capital
Asset Pricing Model relevant.
On the other hand we find those persons who may be characterized as “risk stakers”, whose
benefit is the reward for the entrepreneurship initiative, the NPV of a project. But, counterbalancing it,
commonly there are not easy solutions to leave a real investment when running bad. These reasons
may define a different pattern than that of the plain NPV orthodox rule to solve a real investment.
There are circumstances which well may require an adequate timing to confirm prospectives and keep
strategic alternatives alive, before assuming almost irreversible positions. In this sense, and for the
sake of the real investment analysis, the above mentioned authors have gone further in the
understanding of business decisions in the light of the principles applied for the financial options
valuation.
This article does not intend to define any recipe. On the contrary, it merely intends to exercise
an alternative thought to deal with issues sometimes addressed by means of recipes. Investment and
financing, and the different levels to analyze them, are yet a vast ground for research. This opinion is
not new, as it evidences the effort of specialists who have attempted to improve our understanding on
these matters for the last years. Significant efforts are, for example, the already mentioned risk
analysis which replaces a deterministic NPV for a probabilistic one, as well as the use of the theory of
options for the project’s evaluation, the EVA approach or the APT in the context of a portfolio analysis.
Concerning this text, several of its paragraphs may suggest lines to depart from fundamentalist
conceptions representing only stages in our mind, in the absence of a “natural order and law”.

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Estado y Sociedad), Buenos Aires, 1985.
8) EDWARDS Jeremy. “Recent Developments in the Theory of Corporate Finance”, Oxford Review of
Economic Policy, vol 3, Nr. 4, 1987
9) ELTON & GRUBER. “Modern Portfolio Theory and Invesment Analysis”, John Wiley & Sons, Inc.,
4th edition, 1991.
10)FAMA. “Risk-Adjusted Discount Rates and Capital Budgeting under Uncertainty”, The Journal of
Finance Economics, August 1977, ps. 3-24
11)FANELLI José. “Tópicos de Teoría y Política Monetaria”, CEDES, Centro de Estudios de Estado y
Sociedad, Buenos Aires, Serie Docente No 5, 1991.
12)FONTAINE Ernesto. “Evaluación Social de Proyectos”, Ediciones Universidad Católica de Chile,
11a. edición, 1997.
13)HICKS, John. “Critical Essays in Monetary Theory”, Oxford University Press, 1967.
14)HICKS, John. “Valor y Capital”. Fondo de Cultura Económica, 3rd. edition in spanish, México,
1968.
 27

15)HOSHI, KASHYAP Y SCHARFSTEIN. “Corporate Structure, Liquidity and Investment: Evidence

from Japanese Industrial Groups”, Quarterly Journal of Economics, February 1991.
16)HULL John. “Introduction to Future and Options Markets”, Prentice-Hall International Editions,
1991.
17)JENKINS & HARBERGUER. “Cost-Benefit Analysis of Investment Decisions”, Harvard Institute for
International Development, 1997.
18)KEYNES, John Maynard. “Teoría General de la Ocupación, el Interés y el Dinero”, 1936. Fondo de
Cultura Económica, 2nd edition in spanish, México 1970.
19)MAYER, Collin. “The Assessment: Financial Systems and Corporate Finance”, Oxford Review of
Economic Policy, vol 3, Nr. 4, 1987
20)MILLER. “Debt and Taxes”, The Journal of Finance, May 1977, ps. 261-275
21)MODIGLIANI y MILLER. “The Cost of Capital, Corporate Finance and the Theory of Investment”,
The American Economic Review, June 1958
22)MODIGLIANI y MILLER. “Corporate Income Taxes and the Cost of Capital: a Correction”, The
American Economic Review, June 1963, ps. 433-443
23)ROSS, WESTERFIELD y JORDAN. “Fundamentals of Corporate Finance”, Irwin, 3rd. edition, 1995
24)SAVVIDES Savvakis. “Risk Analysis in Investment Appraisal”, Project Appraisal, Vol. 9, Nr. 1,
Beech Tree Publishing, 1994.
25)TOBIN James. “Money and Finance in the Macroeconomic Process”, Nobel Lecture published at
the Journal of Money, Credit and Banking, vol. 14, no. 2, May 1982.
26)WISEMAN, Jack, Univertity of York, GB. “La Economía Política del Federalismo”, paper published
at annals of the 20th Annual Meeting of Public Finance, University of Córdoba, Argentina, 1987.

*
In 1994 I began to develop the concepts here exposed, as an attempt to synthesize two subjects of
study, the investment projects’ evaluation and the financial issue. With respect to this, I am very
grateful to the following people:
 Dr. Rodolfo APREDA, Universidad del CEMA, for the compromise of his careful reading of a
preliminary version of this paper, whose valuable comments I have taken into account.
 Phd. Albert BARREIX, Harvard Institute for International Development, for his interest in the
preliminary versions and his stimulus to go ahead with this paper.
 Dr. Antonio LAVOLPE, Consejo Profesional de Ciencias Económicas de la Capital Federal
(CPCECF), for his support as Chairman of that institution for the printing of the basic concepts of
this analytical scope in Universo Económico, magazine of the CPCECF.
 Dra. Alicia REY, Universidad Nacional de Luján, for her commitment when entrusting me to
develop a postgraduate course, implemented in April 1997, for the exposition of the analytical
criterion here presented.
 Dr. Antonio TOMASENIA, Chairman of the Investment Projects’ Evaluation Commission of the
CPCECF, for his trust when in 1994 commended me the development of the course on Financial
Analysis for Investment Projects of the CPCECF, initial step to integrate both concepts under
the scope here synthesized.
 To all the Colleagues who have attended my lectures at the CPCECF, since 1995, for the
compromise evidenced through their critic comments.
1
The quoted terms are in concordance with the definitions of JOHN HICKS {13}.
2
If we alter the set of relative prices, we also modify the value of money in the terms of its purchasing
power capacity. Furthermore, we can adopt for projections not only the prevailing prices at present, but
also any others sets of them we can guess as relevant for future. Nevertheless, future will remain as
an unknown fact.
3
Up to the two questions closing this point, these concepts were originally published in Universo
Económico, magazine of the CPCECF, {1}. Instead and spanning both questions, the concepts here
developed were exposed at the “30 Jornadas Nacionales e Internacionales de Finanzas Públicas”,
Universidad Nacional de Córdoba, Ciudad de Carlos Paz, Córdoba (Argentina), in September 1997,
 28

and at the “11as. Jornadas Regionales para Profesionales en Ciencias Económicas”, Federación
Argentina de Consejos Profesionales en Ciencias Económicas, CPCECF, Buenos Aires, November
1997.
4
We refer to the model which has its origin in the paper those authors published in 1958 {21}. Their
“propositions” and the functional relationships satisfying them are an obliged reference at any text-
book of corporate financing. In this paper the mentioned authors sometimes will be referred to with
their initials, as M&M.
5
The quotient between the money expression of the Net Present Value of a project over the required
investment.
6
By definition, the IRR is the rate with which the present value of the expected future incomes, or net
benefits, equals the value of the present money invested into a project. In turn, the YTM is the average
rate required on a bond for equaling the present value of the future payoffs with the market price of
that bond.
7
Anytime for the project we find that it is NPV0.
8
The assumptions described have a strictly correspondence with those adopted by MODIGLIANI and
MILLER {21}.
9
It’s not a surprising matter the common use of a unique average rate “r” as the cut-off rate for a
project evaluation. The care of reflecting the differentials over time which may be introduced by
considering the TSIR appears as less relevant than a correct weight for the premium risk which r will
bears. The magnitude of the risk over-rate easily off sets the importance of the time differentials in the
cost of money. Moreover, if time differentials becomes relevant it is also in terms of risk considerations
along several periods when dealing with the residual expected returns derived from a commercial
activity and not from a money contract. The word “expected” denotes a variable with mean and
variance where this last one, in turn, defines the risk premium over-rate for r.
10
See, for example, COPELAND and WESTON {4}, Chapter 11 “Capital Structure and the Cost of
Capital: Theory”, page 280.
11
Or any other guessed at present, as the true future one is uncertain.
12
Recall that the word “efficiency” was avoided, word which is used to denote the “Cost-Efficiency
Analysis” as a particular case of the Cost Benefit Analysis. The cost impact analysis spans the concept
of costs’ efficiency but aiming to the effectiveness of a certain target to fulfil with the project’s
objectives. Also we need to realize that this way to look for the rationality of an action, as a project, is
similar to that exposed through the “logical-framework” analysis.
13
In the last years the criterion based on the plain calculus of the project’s NPV was a subject of
criticism. To this respect, perhaps, a promissory research to improve our analytical capability to
evaluate business may lean on the theory for the financial options valuation and, as concrete
expression of progress to go further the “deterministic” evaluations, we found the risk-analysis based
on identifying a probabilistic distribution for the NPV of a project.
14
JACK WISEMAN {26}.
15
The theoretical framework exposed as from this point led to develop a methodology for its
empirical appliance to the financial analysis of investment projects, in the context of the firm
which will carry the project out. To analyze both elements are the target of the lectures in
Financial Analysis for Investment Projects at the CPCECF.
16
Although the lender would be a public institution, we may note that we are talking about contracts for
which it acts accordingly to the civil and commercial law as a private subject.
17
As a debt always lacking any kind of risk was assumed, the rate of interest to pay for it is identical to
the opportunity cost of that debt, with the consequence that its market value equals the nominal
rD . D
amount of the outstanding debt, that is to say, V D Ζ ΖD
rD
 29

18
rf
We need to note that, at the expression of the Capital Recoupment Factor CRF Ζ ,
1 ϑ (1 Η rf ) ϑ n
when the temporal horizon tends to infinite, n , then the factor’s value tends to the risk-free rate,
CRF rf.
19
In our case this oughts to the fact that, with a constant differential for the risk-premium rU-rf at all the
considered periods, the certainty equivalent of F at each one of those periods has an amount
progressively diminishing as we move away along time.
20
At this point, the Weighted Average Capital Cost as stated by M&M would be WACC=rU(1-t).
21
On this way we find a meaningful methodology of risk analysis for project’s evaluation aimed to
narrow the numerator’s variance, hence reducing the risk cost at the denominator. Notwithstanding
which the pertinent rate to discount the expected results is, yet remains as a subject of research.
Perhaps, this matter requires us a deeper understanding about systematic and non-systematic risk
together with the treatment of the risk arising from the interest rates’ volatility. (See for example,
SAVVAKIS {24}.
22
This assertion stands regardless of taxes. In the absence of the tax on incomes, from NPV= -I+F/rU
F ϑ rU . I
we obtain NPV Ζ In turn, under its presence and in order to get a positive first derivate for
rU
NCRSE, taxes are deducted only from the expected inflow exceeding the return required on the
investment.
23
Generically, the Gross Capitalization Rate becomes from the expression GCR=1+NCR. When at
[39] we eliminate NW at the numerator with its equivalent term I-D at the denominator, the equities’
value remains expressed again accordingly to the [29] function.
24
John Maynard KEYNES {18}.
25
The moral risk also enables a double reading with respect to over-indebtedness. By one side we can
associate it with accomplishing a situation as to weaken the creditors’ negotiation capacity to obtain
the strictly fulfillment of the words of debt contracts and, by the other, those cases denoting a masked
way for the creditor to get control over the debtor.
26
MODIGLIANI and MILLER, {21}.
27
In as much as the interests on debt are deductible to determine the taxable income, it can be
demonstrated that the opportunity cost of the owned capital rE is not affected by taxation as it is
denoted by the function [27]. On the contrary, as the income tax reduces the inflows to be perceived
with respect to the amount invested, its presence effectively has incidence over the capitalization rate.
28
Avinash DIXIT and Robert PINDYCK {6}, pages 6 and 7.
29
See for example, Aswath DAMODARAN {5}.
30
ELTON & GRUBER {9}, chapter 14.
31
It is worth noting we are supponsing that ru, with its risk-premium over a risk free rate, embodies the
cost of the sistematic risk attributable to a specified sector of activity. This rate may bear not only the
risk profile of that economic sector, but also the risk of changes in the time cost for money (rf).
32
Avinash DIXIT and Robert PINDYCK {6}.