The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life:

A Clarification
James A. Miles; John R. Ezzell
The Journal of Financial and Quantitative Analysis, Vol. 15, No. 3. (Sep., 1980), pp. 719-730.
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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS

Volume XV, No. 3 , September 1980

THE WEIGHTED AVERAGE COST OF CAPITAL, PERFECT CAPITAL MARKETS,

AND PROJECT LIFE:

A CLARIFICATION

J a m e s A . Miles and J o h n R . E z z e l l *

For f i n a n c i a l management t o make wealth maximizing c a p i t a l budgeting d e c i s i o n s , a model t h a t w i l l determine c o r r e c t l y t h e market v a l u e of a p r o j e c t ' s
l e v e r e d c a s h flows i s r e q u i r e d .

A c a p i t a l budgeting model should account n o t

only f o r t h e e f f e c t s of t h e investment d e c i s i o n , b u t a l s o f o r t h e e f f e c t s of
t h e f i n a n c i n g d e c i s i o n and t h e i n t e r a c t i o n s between t h e two d e c i s i o n s .

In per-

f e c t c a p i t a l markets a l l t h e e f f e c t s of t h e f i n a n c i n g d e c i s i o n p e r t a i n t o t h e
t a x s h i e l d c r e a t e d by d e b t f i n a n c i n g .

Thus, a s o r i g i n a l l y shown by Modigliani

and M i l l e r [81, t h e v a l u e of a p r o j e c t ' s l e v e r e d c a s h flow stream e q u a l s t h e

market v a l u e t h e stream would have i f it were unlevered p l u s t h e market v a l u e
of t h e stream of t a x s a v i n g s on i n t e r e s t payments a s s o c i a t e d w i t h t h e d e b t employed t o f i n a n c e t h e p r o j e c t .

While t h i s r e s u l t i s completely g e n e r a l w i t h

r e s p e c t t o t h e s p e c i f i c p r o c e s s e s u t i l i z e d by t h e market t o v a l u e t h e two components, MM s p e c i f i e d t h e v a l u e of t h e unlevered component a s t h e p r e s e n t v a l u e

of t h e unlevered c a s h flows d i s c o u n t e d a t t h e a p p r o p r i a t e r i s k a d j u s t e d unleve r e d c o s t of c a p i t a l and they s p e c i f i e d t h e v a l u e of t h e t a x s a v i n g s component
a s t h e p r e s e n t v a l u e of t h e t a x s h i e l d on i n t e r e s t d i s c o u n t e d a t t h e c o s t of
debt.'

Accordingly, t h e v a l u e of a p r o j e c t ' s l e v e r e d cash flows i s s p e c i f i e d

a s t h e sum of t h e s e two p r e s e n t v a l u e s , one r e p r e s e n t i n g t h e e f f e c t s of t h e i n vestment d e c i s i o n and t h e o t h e r c a p t u r i n g t h e e f f e c t s of t h e f i n a n c i n g d e c i s i o n .

The MM v a l u a t i o n model has been extended t o normative c a p i t a l budgeting analy-

s i s by Myers [91 i n terms of t h e a d j u s t e d p r e s e n t v a l u e (APV) model.

I n both t h e l i t e r a t u r e and p r a c t i c e of c a p i t a l budgeting i s observed, howe v e r , a p r e f e r e n c e f o r s p e c i f y i n g t h e v a l u e of t h e l e v e r e d c a s h flows i n terms
of a s i n g l e p r e s e n t v a l u e t h a t r e f l e c t s t h e combined e f f e c t s of both t h e i n v e s t ment and f i n a n c i n g d e c i s i o n s .

T h i s approach i s u s u a l l y o p e r a t i o n a l i z e d by

U n i v e r s i t y o f G e o r g i a and P e n n s y l v a n i a S t a t e U n i v e r s i t y , r e s p e c t i v e 1y

'see Modigliani and M i l l e r [81 f o r a d i s c u s s i o n of why i t might be approp r i a t e t o d i s c o u n t t h e t a x s h i e l d on i n t e r e s t a t t h e c o s t of d e b t . A condit i o n s u f f i c i e n t t o j u s t i f y t h i s v a l u a t i o n method i s t h a t b o t h t h e f i r m ' s d e b t
and t h e t a x s h i e l d s a r e r i s k l e s s .

d i s c o u n t i n g t h e unlevered c a s h flows a t a r a t e s p e c i f i e d a s a weighted average

T h i s o p e r a t i o n a l model of

of t h e f i r m ' s a f t e r - t a x c o s t s of d e b t and e q u i t y . 2

p r o j e c t v a l u a t i o n i s f r e q u e n t l y r e f e r r e d t o a s t h e "textbook" approach.
The p o p u l a r i t y of t h e textbook approach can probably be a t t r i b u t e d mainly
t o two f a c t o r s .

F i r s t , i f t h e p r o j e c t i n q u e s t i o n i s of t h e same r i s k c l a s s

a s t h e f i r m ' s p o r t f o l i o of e x i s t i n g p r o j e c t s , t h e c o s t s of d e b t and e q u i t y can

b e e s t i m a t e d on t h e b a s i s of t h e observed market r a t e s of r e t u r n on t h e f i r m ' s
d e b t and e q u i t y s e c u r i t i e s .

The f i r m ' s unlevered c o s t of c a p i t a l , on t h e o t h e r

hand, has no d i r e c t l y o b s e r v a b l e market c o u n t e r p a r t .

Second, t h e textbook ap-

proach f a c i l i t a t e s d e c e n t r a l i z e d c a p i t a l e x p e n d i t u r e a n a l y s e s and c h o i c e s where

t h e f i n a n c i n g and investment d e c i s i o n s a r e o r g a n i z a t i o n a l l y s e p a r a t e d .

Thus,

lower l e v e l managers a r e provided w i t h a s i n g l e d i s c o u n t r a t e which i s intended

t o r e f l e c t not only t h e p r o j e c t ' s operating r i s k , but a l s o the f i r m ' s financing
p o l i c i e s and which i s t o be used t o e v a l u a t e ,

a t a decentralized level, the

f i r m ' s investment o p p o r t u n i t i e s .
I n r e c e n t y e a r s , however, a p e r s i s t e n t c o n t r o v e r s y i n t h e c a p i t a l budgeti n g l i t e r a t u r e has been concerned w i t h t h e e f f e c t of p r o j e c t l i f e on t h e v a l i d i t y of t h e textbook approach t o p r o j e c t a n a l y s i s .

Although i t i s u s u a l l y ac-

c e p t e d t h a t t h e textbook weighted average c o s t of c a p i t a l (WACC) i s an approp r i a t e d i s c o u n t r a t e f o r e i t h e r of t h e p o l a r assumptions of (1) a one-year proj e c t l i f e o r ( 2 ) l e v e l p e r p e t u a l p r o j e c t c a s h f l o w s , a number of a u t h o r s have
argued t h a t t h e textbook approach does n o t g e n e r a l l y p r o v i d e c o r r e c t v a l u a t i o n s
of uneven f i n i t e c a s h f l o w s . 3

I n t h i s paper we examine t h e v a l i d i t y of t h e

textbook approach f o r uneven f i n i t e c a s h flows i n t h e c o n t e x t of t h e MM p e r f e c t

c a p i t a l markets r e s u l t

t h a t t h e market v a l u e of l e v e r e d cash flows i s e q u a l

t o t h e unlevered v a l u e p l u s t h e v a l u e of t a x s a v i n g s due t o d e b t f i n a n c i n g .
Our a n a l y s i s shows t h a t i f t h e unlevered c o s t of c a p i t a l , t h e c o s t of d e b t , t h e
t a x r a t e , and t h e market v a l u e l e v e r a g e r a t i o a r e c o n s t a n t f o r t h e d u r a t i o n of
a p r o j e c t , t h e n t h e v a l u e of a p r o j e c t ' s l e v e r e d c a s h flows can be o b t a i n e d by
d i s c o u n t i n g t h e unlevered cash flows a t a r a t e :
1. t h a t i s i n v a r i a n t w i t h r e s p e c t t o t h e time p a t t e r n and d u r a t i o n

of t h e l e v e r e d c a s h flows and
2.

t h a t i s e q u a l t o t h e textbook WACC.

Thus o u r a n a l y s i s i m p l i e s t h a t t h e textbook approach i s a s p e c i a l c a s e of t h e

See N a n t e l l and Carlson [ l o ] f o r a d i s c u s s i o n of c o s t of c a p i t a l s p e c i f i c a t i o n s . They r e f e r t o t h e textbook c o s t of c a p i t a l a s t h e "modern" s p e c i f i c a tion.

3

S e e , f o r example [ l l ,

[51, [91, and [111.

MM v a l u a t i o n r e s u l t and M y e r ' s APV c a p i t a l b u d g e t i n g r u l e .

The c r i t i c a l a s s u m p t i o n f o r e s t a b l i s h i n g t h e v a l i d i t y of t h e t e x t b o o k app r o a c h i s concerned w i t h t h e f i r m ' s f i n a n c i n g p o l i c y .

n o t an i s s u e .

The p r o j e c t ' s l i f e i s

When management a c t s t o m a i n t a i n a c o n s t a n t d e b t t o t o t a l v a l u e

r a t i o , i n t e r m s o f r e a l i z e d market v a l u e s , t h e i n v e s t m e n t d e c i s i o n i m p a c t s upon
t h e r i s k i n e s s a s w e l l a s t h e magnitude o f f u t u r e t a x s h i e l d s c r e a t e d by d e b t
financing.

Even though t h e f i r m might i s s u e r i s k l e s s d e b t , i f f i n a n c i n g p o l i c y

i s t a r g e t e d t o r e a l i z e d market v a l u e s , t h e amount o f d e b t o u t s t a n d i n g i n f u t u r e
p e r i o d s i s n o t known w i t h c e r t a i n t y ( u n l e s s t h e i n v e s t m e n t i s r i s k l e s s ) and,
c o n s e q u e n t l y , t h e magnitude o f t h e t a x s h i e l d s c a n n o t b e known w i t h c e r t a i n t y .

I f , f o r example, r e a l i z e d market v a l u e s a r e below o r i g i n a l e x p e c t a t i o n s , t h e n

t h e amount o f o u t s t a n d i n g d e b t w i l l be a d j u s t e d a c c o r d i n g l y c r e a t i n g a reduct i o n i n t h e magnitude o f r e a l i z e d t a x s a v i n g s from o r i g i n a l e x p e c t a t i o n s .

In

t h i s p a p e r we e s t a b l i s h t h e c o r r e c t l i n k a g e between t h e r i s k i n e s s of t h e i n v e s t ment, a s embodied i n t h e u n l e v e r e d d i s c o u n t r a t e , and t h e r i s k i n e s s o f t h e f u t u r e t a x s a v i n g s on i n t e r e s t payments when t h e market v a l u e l e v e r a g e r a t i o i s

held constant.

This c o r r e c t linkage provides t h e b a s i s f o r e s t a b l i s h i n g t h e

v a l i d i t y o f t h e t e x t b o o k WACC i n p e r f e c t c a p i t a l m a r k e t s .
S e c t i o n I o f t h e p a p e r i d e n t i f i e s t h e assumptions used i n S e c t i o n I1 t o
d e r i v e a model f o r o b t a i n i n g t h e v a l u e o f a l e v e r e d s t r e a m by d i s c o u n t i n g t h e
u n l e v e r e d s t r e a m by a s i n g l e d i s c o u n t r a t e .
c o u n t r a t e i s e q u a l t o t h e t e x t b o o k WACC.

S e c t i o n I11 p r o v e s t h a t t h i s d i s F i n a l l y , S e c t i o n I V summarizes t h e

paper.

4A number of w r i t e r s i n c l u d i n g Bar-Yosef
[21 , E z z e l l and P o r t e r [61 , and
Linke and K i m [71 have been a b l e t o show t h a t a c o n s t a n t c o s t o f e q u i t y , a cons t a n t c o s t of d e b t , a c o n s t a n t market v a l u e l e v e r a g e r a t i o , and a c o n s t a n t
weighted a v e r a g e c o s t o f c a p i t a l a r e i n t e r n a l l y c o n s i s t e n t c o n d i t i o n s f o r any
t i m e p a t t e r n o f c a s h f l o w s . But t h e s e a n a l y s e s d i d n o t a t t e m p t t o e s t a b l i s h
l i n k a g e between t h e MM p e r f e c t market v a l u a t i o n model and t h e t e x t b o o k weighted
a v e r a g e c o s t o f c a p i t a l . A l s o s e e Beranek [41 f o r t h e d e r i v a t i o n of a c a p i t a l
b u d g e t i n g model employing a book v a l u e weighted a v e r a g e c o s t of c a p i t a l .

5That f u t u r e t a x s h i e l d s a r e r i s k y when management a c t s t o m a i n t a i n a cons t a n t d e b t - t o - t o t a l v a l u e r a t i o was r e c o g n i z e d by Myers who n o t e d " . . . t h a t a l though t h e t a x s h i e l d a s s o c i a t e d w i t h any d e b t i n s t r u m e n t i s s a f e , t h e aggreg a t e value of t h e instrument o b t a i n a b l e i s uncertain."
( [ 9 , p . 221) For h i s
a n a l y s i s , however, Myers was a p p a r e n t l y u n w i l l i n g t o make t h e s t r o n g r e b a l a n c i n g assumption n e c e s s a r y t o m a i n t a i n a c o n s t a n t market v a l u e l e v e r a g e r a t i o .

I.

The Assumptions

We s h a l l assume t h e f o l l o w i n g :

1. C a p i t a l Markets a r e p e r f e c t .

Consequently, t h e market v a l u e of any

l e v e r e d c a s h flow stream e q u a l s t h e market v a l u e of t h e unlevered component p l u s t h e market v a l u e of t h e t a x s a v i n g s on i n t e r e s t payments.

To be a s g e n e r a l a s p o s s i b l e , we e x p r e s s t h e v a l u e of t h e l e v e r e d
L

stream, Vk, a s

where

= t h e expected unlevered cash flow a t time i ;

= t h e v a l u e of o u t s t a n d i n g d e b t a t time i-1;

Bi-l

= t h e c o s t of d e b t ;

= t h e f i r m ' s income t a x r a t e ;

dU
ij

= t h e market r a t e a p p r o p r i a t e f o r d i s c o u n t i n g t h e time i expected

unlevered c a s h flow i n p e r i o d j where f o r each i = k + 1,
k + 2,
i; and
T, j = k + l , k + 2 ,

...

d:.

...,

= t h e market r a t e a p p r o p r i a t e f o r d i s c o u n t i n g t h e time i expected

,T
t a x s a v i n g s i n p e r i o d j where f o r each i = k + 1, k + 2 ,
j = k + l , k + 2 ,
i.

...

...,

I n e q u a t i o n ( I ) , k r e p r e s e n t s t h e p o i n t i n time a t which market v a l u e

i s r e a l i z e d , t h e i t s r e p r e s e n t t h e p o i n t s i n time f o l l o w i n g k a t which
c a s h flows a r e r e a l i z e d , and t h e j ' s r e p r e s e n t t h e p e r i o d s between k
and each i .
2 . A t any time k , p o i s t h e a p p r o p r i a t e r a t e f o r d i s c o u n t i n g t h e time i

expected unlevered cash flow i n p e r i o d j where p

3.

is referred t o as

That i s , we assume, f o l l o w i n g MM,

" t h e unlevered c o s t of c a p i t a l . "

t h a t dyj = p o for 0 < k < j

T.

The f i r m m a i n t a i n s a c o n s t a n t l e v e r a g e r a t i o , L , s o t h a t B

i-1 = LVi-l.
I f , a t t h e end of any p e r i o d , t h e d e b t t o t o t a l v a l u e r a t i o does n o t

e q u a l L , we assume t h a t t h e f i r m u n d e r t a k e s f i n a n c i a l t r a n s a c t i o n s t o
6
r e s t o r e t h e r a t i o t o L.
'whether m a i n t a i n i n g a c o n s t a n t market v a l u e l e v e r a g e r a t i o , L , i s i n some
s e n s e t h e " b e s t " f i n a n c i n g p o l i c y i s n o t o u r concern. We make t h i s assumption
simply because t h e textbook weighted average c o s t of c a p i t a l i s s p e c i f i e d i n

4. At time k = i-1, the appropriate rate for discounting the time i tax
That is, d. = r for j = i = k + 1.
11

In view of assumption 3, it is only at time i-1 that B

is known for

i-1

certain. Thus, unlike MM, we make no assumptions pertaining to the

savings is r, the cost of debt.

value of dT for i > k + 1; rather we allow the appropriate values to

ij

be deduced from the analysis.

The objective of our analysis is to determine the composite set of rates

pij

that will satisfy

where p . is the appropriate rate for discounting the time i unlevered cash flow
11

Our analysis will show that

in period j to obtain the levered market value, vL

0'

if the firm maintains a constant leverage ratio in terms of realized market

values, p . . is constant for each and every i and j and is equal to the so-called

13

textbook formulation of the weighted average cost of capital.

11.

Analysis of the Investment-Financing Interactions

A clear understanding of the meaning of assumption 2 is critical to under-

standing our analysis of the interactions between the firm's investment and

Letting V [ I represent a generalized value operator

k

that generates the time k market value of the cash flow stream within the

financing decisions.

brackets, assumption 2 implies that

X.

for 0 (k

< i (T

since p

is the "correct" discount rate for all future periods.

Equation (3) in conjunction with the value additivity principle imples that

time k.

vUk

"/

represents the value of the unlevered component at

Equations (3) and (4) together imply

for 0 ( k < T where

Footnote 6 continued:

terms of a constant L. Therefore, for an analysis to provide a meaningful

basis on which to evaluate the conceptual validity of the textbook specifica-

tion, L must be maintained constant. We should not be surprised to "discover"

that the textbook approach does not give correct solutions when other financing

patterns are followed.

(5)

where 0

k < T-1

The v a l u a t i o n p r o c e s s embodied i n e q u a t i o n s ( 3 ) , ( 4 ) , a n d ( 5 ) i m p l i e s t h a t a t
t i m e T-1,

t h e v a l u e o f t h e u n l e v e r e d component i s

(6)

and a t t i m e T-2,

S u b s t i t u t i n g equation (6) i n t o ( 7 ) gives us

C o n t i n u i n g t h i s s i m p l e backward i t e r a t i o n p r o c e d u r e back t o t i m e 0 r e s u l t s i n

Since equation ( 9 ) is a d i r e c t implication of assumption 2 , equations ( 3 )

may seem t o b e l a b o r t h e o b v i o u s .

(8)

We i n c l u d e them t o s e t f o r t h c l e a r l y t h e

v a l u a t i o n p r o c e s s i m p l i e d by a s s u m p t i o n 2 and t h e r e b y t o s e t t h e s t a g e f o r d e a l ing w i t h t h e l e s s obvious problem of determining t h e v a l u e of t h e t a x s a v i n g s

on i n t e r e s t payments.
Employing o u r t h i r d a s s u m p t i o n t h a t t h e l e v e r a g e r a t i o , i n t e r m s o f r e a l i z e d m a r k e t v a l u e s , i s h e l d c o n s t a n t , e q u a t i o n (1) c a n now b e r e w r i t t e n a s

I t i s o b v i o u s from e q u a t i o n ( 1 0 ) t h a t i f t h e l e v e r a g e r a t i o i s h e l d c o n s t a n t i n

t e r m s of L =

Bi-l

,
vL1-1
.

t h e m a g n i t u d e o f t h e t a x s a v i n g s a t a n y t i m e i d e p e n d s upon

t h e v a l u e o f t h e l e v e r e d cash flow stream a t time i - 1 ,

vL1-1r b u t

Vi-L

upon t h e v a l u e o f t h e t a x s a v i n g s component a t t i m e ( i - l ) ,V:

Thus, $ c a n -

1-1'

n o t g e n e r a l l y b e d e t e r m i n e d by s i m p l y a d d i n g a n i n d e p e n d e n t l y d e t e r m i n e d vT

0 when t h e f i r m a c t s t o m a i n t a i n a c o n s t a n t m a r k e t v a l u e l e v e r a g e r a t i o .

'dU

Rather

L
To account f o r t h e
it i s n e c e s s a r y t o determine V
and vT simultaneously.
O'L
0
we w i l l employ t h e backward i t e r a t i o n proceinterdependence between V Tand V
0
0
d u r e which has been shown t o be i m p l i c i t i n e q u a t i o n ( 9 ) .
We i n i t i a t e t h e backward i t e r a t i o n procedure by e x p r e s s i n g t h e v a l u e of
t h e l e v e r e d stream a t T-1 a s

(11)

L
T~LV
T- 1

where e q u a t i o n ( 3 ) i s u t i l i z e d t o v a l u e t h e unlevered component by d i s c o u n t i n g

t h e unlevered component a t t h e f i r m ' s unlevered c o s t of c a p i t a l , and assumption
4 i s u t i l i z e d t o d i s c o u n t t h e t a x s a v i n g s a t t h e f i r m ' s c o s t of d e b t .

e q u a t i o n (11) f o r

~ i - ~

Solving

g i v e s us

Equation ( 1 2 ) r e v e a l s t h a t

i s t h e a p p r o p r i a t e d i s c o u n t f a c t o r f o r v a l u i n g a l e v e r e d stream a t time T-1.

As

a s p e c i a l c a s e , i f ~ = le q,u a t i o n (13) shows t h a t p TT i s t h e c o r r e c t r i s k a d j u s t e d d i s c o u n t r a t e f o r t h e s i n g l e p e r i o d c a s h flow.

A t time T-2,

t h e v a l u e of t h e l e v e r e d cash flow i s

i s t h e a p p r o p r i a t e r a t e f o r d i s c o u n t i n g t h e v a l u e of t h e time
(T-1) (T-1)
L

The c o r r e c t s p e c i f i c a t i o n of d (T-1) (T-1)

T-1 l e v e r e d market v a l u e t o time T-2.

where d

i s a s t r a i g h t f o r w a r d i m p l i c a t i o n of o u r assumptions and a n a l y s i s t o t h i s p o i n t .
We can use e q u a t i o n ( 6 ) t o s u b s t i t u t e

vU
T- 1

(1 +

f o r ]i i n e q u a t i o n (12)
T

obtaining

Equation (15) shows t h a t

constant scale factor.

u
a r e q u a n t i t i e s t h a t d i f f e r o n l y by a
T- 1
L

are
T h i s means t h a t a t any time k < T-1, v ~ 1- and vU
T- 1

vL
T-1

and V

p e r f e c t l y c o r r e l a t e d random v a r i a b l e s and must be valued a c c o r d i n g l y .

(5) shows t h a t vU

Equation

should be d i s c o u n t e d a t t h e f i r m ' s unlevered c o s t of c a p i t a l

T- 1
L
Consequently, VT-l should a l s o be d i s f o r v a l u a t i o n a t any time p r i o r t o T-1.
counted a t p

implying t h a t

S u b s t i t u t i n g e q u a t i o n s (12) and (16) i n t o e q u a t i o n (14) and s o l v i n g f o r V

L
T- 2

g i v e s us

Equation (17) r e v e a l s t h a t

Continuing w i t h s i m i l a r a n a l y s i s back t o time 0 shows t h a t

(19)

where

o r , solving f o r p

i s independent of t h e magnitude and timing

0
of t h e unlevered c a s h flow s t r e a m , t h e n t h e c o r r e c t d i s c o u n t r a t e f o r v a l u i n g
Equation ( 2 0 ) e s t a b l i s h e s t h a t i f p

a l e v e r e d stream i s a l s o independent of t h e magnitude and timing of t h e unleve r e d stream.

Thus, p

111.

i s dependent only upon p o l

7,

L , and r .

The Weighted Average Cost of C a p i t a l

The n e x t s t e p i s t o prove t h a t t h e textbook f o r m u l a t i o n of t h e weighted

a v e r a g e c o s t of c a p i t a l f o l l o w s from o u r p r e v i o u s a n a l y s i s .
such t h a t 0

k < T.

The expected end-of-period

L e t k b e any p e r i o d

c a s h flow t o e q u i t y can be

written a s

The f i r m r e c e i v e s t h e unlevered component p l u s t h e t a x s a v i n g s on i n t e r e s t payments.

Then, i n t e r e s t payments a r e deducted.

I f Bk+l < Bk,

t h e amobnt of d e b t

o u t s t a n d i n g i s reduced and c a s h i s used t o r e t i r e o u t s t a n d i n g d e b t .

o t h e r hand, Bk+l

I f , on t h e

> Bk, t h e r e i s a n e t i n c r e a s e i n c a s h f l o w .

Finally, equity
L
owns (1-L)vL
of t h e s t r e a m ' s f u t u r e v a l u e .
S u b s t i t u t i n g LvL f o r B and LV
k+l
k
k
k+l
f o r B ~ + we
~ ,can r e a r r a n g e terms s o t h a t t h e e x p e c t e d end-of-period c a s h flow
t o equity i s

Dividing t h i s e x p r e s s i o n by (1-L)vL t h e time k v a l u e of e q u i t y , y i e l d s

k'

i s t h e e x p e c t e d r a t e of r e t u r n on e q u i t y f o r t h e ( k + 1) p e r i o d .
(k+l)
*
The f i r s t term on t h e r i g h t - h a n d s i d e o f e q u a t i o n ( 2 1 ) i s simply (1 + p ) / ( l - L )

where p S

a s i m p l i e d by t h e f a c t t h a t p
stream.

i s t h e r e q u i r e d r a t e of r e t u r n f o r t h e l e v e r e d

Hence, e q u a t i o n ( 2 1 ) can be w r i t t e n a s

Equation ( 2 2 ) p r o v e s t h a t t h e c o s t of e q u i t y i s independent of t h e p a r t i c u l a r
time p e r i o d .

Solving equation (22) f o r p

yields

Equation ( 2 3 ) i s t h e t e x t b o o k f o r m u l a t i o n of t h e weighted a v e r a g e c o s t of
capital.

IV.

Summary

B a s i c a l l y , two approaches t o t h e v a l u a t i o n of a l e v e r e d s t r e a m have appeared i n t h e l i t e r a t u r e .

The t e x t b o o k approach assumes a c o n s t a n t c o s t of

e q u i t y , a c o n s t a n t c o s t of d e b t , and a c o n s t a n t l e v e r a g e r a t i o .

The Modigliani

and M i l l e r approach assumes a c o n s t a n t u n l e v e r e d c o s t of c a p i t a l and a c o n s t a n t

c o s t of d e b t .

The a d j u s t e d p r e s e n t v a l u e model developed by Myers i s a norma-

t i v e i m p l i c a t i o n o f t h e MM v a l u a t i o n approach.

Our a n a l y s i s shows t h a t t h e

t e x t b o o k approach i s a l s o an i m p l i c a t i o n of t h e MM approach and i s , t h e r e f o r e ,

a s p e c i a l c a s e of Myers' MM-based APV model.
I n p a r t i c u l a r , we have shown i n e q u a t i o n s ( 1 9 ) , ( 2 0 ) , and (23) t h a t i n
p e r f e c t c a p i t a l markets where t h e u n l e v e r e d d i s c o u n t r a t e ( p ) , t h e c o s t of
0
d e b t ( r ) , t h e t a x r a t e ( T ) , and t h e market v a l u e l e v e r a g e r a t i o a r e c o n s t a n t

f o r t h e d u r a t i o n o f an unlevered cash flow stream, t h e v a l u e of t h e l e v e r e d

c a s h f l o w s t r e a m c a n b e o b t a i n e d by d i s c o u n t i n g t h e u n l e v e r e d component a t a
c o n s t a n t r a t e t h a t i s e q u a l t o t h e t e x t b o o k WACC.

I n t h e d e r i v a t i o n o f equa-

t i o n s ( 1 9 ) , ( 2 0 ) , and ( 2 3 ) , no a s s u m p t i o n s were made r e g a r d i n g e i t h e r t h e t i m e

p a t t e r n o r t h e d u r a t i o n o f t h e u n l e v e r e d component.

Thus, t h i s p a p e r h a s demon-

s t r a t e d t h a t we c a n d i s p e n s e w i t h t h e two p o l a r s u f f i c i e n t a s s u m p t i o n s r e g a r d i n g p r o j e c t l i f e g e n e r a l l y i d e n t i f i e d w i t h t h e v a l i d i t y o f t h e t e x t b o o k WACC:
(1) t h e p r o j e c t h a s a o n e - y e a r l i f e ; o r ( 2 ) t h e p r o j e c t ' s c a s h f l o w s a r e a l e v e l

perpetuity.

The c r i t i c a l a s s u m p t i o n p e r t a i n s n o t t o p r o j e c t l i f e , b u t r a t h e r

t o t h e f i n a n c i n g p o l i c y f o l l o w e d by t h e f i r m .
Our a n a l y s i s assumes ( a s s u m p t i o n 3 ) t h a t t h e f i r m m a i n t a i n s a c o n s t a n t
l e v e r a g e r a t i o , L = Bi l / l ,

by a d j u s t i n g t h e amount o f o u t s t a n d i n g d e b t ,

t o t h e r e a l i z e d l e v e r e d m a r k e t v a l u e , ViPl, i n e a c h p e r i o d . F o r a one1-1'
y e a r p r o j e c t l i f e t h e l e v e r a g e r a t i o i s L = B /vL a n d i s c o n s t a n t by d e f i n i t i o n
0 0
s i n c e n e i t h e r an o p p o r t u n i t y n o r a r e q u i r e m e n t a r i s e s t o r e b a l a n c e t h e c a p i t a l

B,

structure.

However, s i n c e f o r any c a s h f l o w d u r a t i o n e x c e e d i n g o n e y e a r , i n -

c l u d i n g a l e v e l p e r p e t u i t y , r e a l i z e d and e x p e c t e d l e v e r e d m a r k e t v a l u e s may
d i f f e r a s a c o n s e q u e n c e o f t h e r i s k i n h e r e n t i n t h e u n l e v e r e d component, a c t i v e
L
r e b a l a n c i n g by t h e f i r m i s r e q u i r e d t o m a i n t a i n a c o n s t a n t L = Bi-l/Vi-l.
This
r e b a l a n c i n g r e q u i r e m e n t i s o b s c u r e d when a l e v e l p e r p e t u i t y i s assumed.

In

t h i s c a s e , s i n c e b o t h t h e e x p e c t e d v a l u e o f d e b t , B, and t h e e x p e c t e d l e v e r e d
L
, a r e c o n s t a n t by i m p l i c a t i o n , t h e l e v e r a g e r a t i o , L = B/V L , i s a l s o

value, V

c o n s t a n t by i m p l i c a t i o n .

Nevertheless, i m p l i c i t i n t h i s constant leverage

r a t i o i s t h e rebalancing p o l i c y expressed i n terms of assumption 3 .

Therefore,

t h a t t h e t e x t b o o k WACC y i e l d s c o r r e c t v a l u a t i o n s f o r e i t h e r a s i n g l e - p e r i o d p r o j e c t o r a p r o j e c t with l e v e l p e r p e t u a l cash flows i s a consequence, n o t of proj e c t l i f e p e r s e , a s h a s been a r g u e d i n t h e l i t e r a t u r e , b u t r a t h e r o f m a i n t a i n ing i n d i r e c t l y a constant leverage r a t i o .

F u r t h e r m o r e , t h e f a i l u r e o f t h e lit-

e r a t u r e g e n e r a l l y t o p r o d u c e c o r r e c t v a l u a t i o n s f o r uneven f i n i t e c a s h f l o w s
with t h e textbook approach i s likewise n o t a matter of p r o j e c t l i f e , b u t i n s t e a d
t h e r e s u l t of assuming a d e b t t r a n s a c t i o n schedule t h a t allows t h e l e v e r a g e
r a t i o t o vary.
The c h o i c e between t h e t e x t b o o k and MM-APV a p p r o a c h e s t o c a p i t a l b u d g e t i n g
a n a l y s i s d e p e n d s on w h e t h e r i t i s (1) t h e d e b t - r e p a y m e n t s c h e d u l e o r ( 2 ) t h e
l e v e r a g e r a t i o t h a t i s exogenous w i t h r e s p e c t t o r e a l i z e d m a r k e t v a l u e s .

The

g e n e r a l p e r f e c t c a p i t a l m a r k e t s MM-APV model i s n e u t r a l w i t h r e s p e c t t o t h e
f i r m ' s f i n a n c i n g p o l i c y , b u t i t r e q u i r e s e x p l i c i t v a l u a t i o n of t h e t a x b e n e f i t s
of debt financing.

The t e x t b o o k a p p r o a c h i s a s p e c i a l c a s e of t h e g e n e r a l MM-

APV model when t h e l e v e r a g e r a t i o i s exogenous,

and i t e n a b l e s t h e f i r m t o v a l u e

t h e d e b t - r e l a t e d t a x b e n e f i t s i m p l i c i t l y simply by d i s c o u n t i n g t h e unlevered
c a s h flows a t t h e WACC.

However, t h i s approach assumes t h a t t h e f i r m i s a b l e

and w i l l i n g t o m a i n t a i n t h e l e v e r a g e r a t i o a t L = B/V by i s s u i n g more d e b t

when times a r e " b e t t e r " t h a n expected and r e t i r i n g d e b t when times a r e "worse"
t h a n expected.

With a n y o t h e r d e b t p o l i c y , t h e p e r i o d i c d e b t t r a n s a c t i o n s a r e

e i t h e r p a r t i a l l y o r completely exogenous w i t h r e s p e c t t o r e a l i z e d market v a l u e s

and, consequently, t h e l e v e r a g e r a t i o w i l l n o t be c o n s t a n t e x c e p t by chance.
Equations ( 2 1 ) and (22) show t h a t t h e c o s t of e q u i t y i n any g i v e n p e r i o d i s a
f u n c t i o n of t h a t p e r i o d ' s l e v e r a g e r a t i o .

Thus, we cannot determine t h e c o s t

of e q u i t y u n t i l we know t h e l e v e r a g e r a t i o , and we cannot determine t h e l e v e r age r a t i o u n t i l we know t h e l e v e r e d market v a l u e .

v a l u e i s t h e aim of o u r a n a l y s i s .

But, t h e l e v e r e d market

Thus, u n l e s s t h e l e v e r a g e r a t i o and, conse-

q u e n t l y , t h e c o s t of e q u i t y a r e exogenous t o r e a l i z e d market v a l u e s , t h e t e x t book WACC i s n o t an a p p r o p r i a t e d i s c o u n t r a t e f o r normative c a p i t a l budgeting

analysis.

Indeed, i t would seem t h a t t h e p r o s p e c t s of f i n d i n g any normatively

u s e f u l d i s c o u n t r a t e s p e c i f i e d i n terms of an average of e q u i t y and d e b t r a t e s

a r e remote i f t h e f i r m ' s d e b t t r a n s a c t i o n schedule i s exogenous w i t h r e s p e c t
t o r e a l i z e d market v a l u e s .

T h e r e f o r e , when i t i s assumed t h a t t h e d e b t t r a n s -

a c t i o n schedule r a t h e r t h a n t h e l e v e r a g e r a t i o i s exogenous, t h e a n a l y s i s of
c a p i t a l budgeting o p t i o n s should be conducted i n terms of t h e g e n e r a l MM-APV
v a l u a t i o n model.

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"Some New C a p i t a l B u d g e t i n g Theorems." J o u r n a l o f F i n a n c i a l

a n d Q u a n t i t a t i v e A n a l y s i s , Vol. 1 3 (December 1 9 7 8 ) , p p . 809-823.

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ment and t h e A p p r o p r i a t e D i s c o u n t R a t e . " J o u r n a l o f F i n a n c i a l a n d Q u a n t i -

t a t i v e A n a l y s i s , Vol. 1 3 (December 1978) , p p . 831-846.

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~ p 333-391.
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[ill R e i l l y , R .

R.,

and W .

E . Wecker.

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p p . 123-126.