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The Quarterly Review of Economics and Finance 49 (2009) 12191223

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The Quarterly Review of Economics and Finance


journal homepage: www.elsevier.com/locate/qref

Short communication

The weighted average cost of capital is not quite right: A comment


Axel Pierru
IFP, IFP School, Center for Economics and Management, 228-232 Avenue Napoleon Bonaparte, 92852 Rueil-Malmaison, France

a r t i c l e

i n f o

a b s t r a c t
In this journal, Miller [Miller, R. A. (2009). The weighted average cost of capital is not quite right. The Quarterly Review of Economics and Finance, 49, 128138] argues that the standard WACC formula fails to correctly remunerate shareholders and bondholders. This is proved by considering a project yielding a zero net present value. In this comment, we prove that this apparent failure of the standard WACC approach simply stems from the fact that, in Millers example, the projects debt ratio is implicitly assumed constant throughout the projects life, whereas it is not. We also show that the suggested modied WACC formula is not relevant. More generally, we emphasize that, in any year, a projects debt ratio must be dened with respect to the economic value of the project. 2008 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.

Article history: Received 26 October 2007 Received in revised form 16 June 2008 Accepted 18 August 2008 Available online 29 August 2008 JEL classication: G11 G3 Keywords: WACC Cost of capital Debt ratio Leverage ratio

1. Inconsistency of two assumptions in Millers proof In this journal, Miller (2008) argues that the standard weighted average cost of capital (WACC) formula is a linear approximation of a non-linear relationship. His proof is based on the observation that the constant operating cash ow of a project yielding a zero net present value is not equal to the sum of the constant cash ows that debtholders and shareholders would separately require to earn their respective expected returns. To remedy this, Miller presents a modication of the WACC.

Tel.: +33 147526408; fax: +33 147527066. E-mail address: axel.pierru@ifp.fr.


1062-9769/$ see front matter 2008 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.

doi:10.1016/j.qref.2008.08.002

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A. Pierru / The Quarterly Review of Economics and Finance 49 (2009) 12191223

In this short note, we claim that this apparent failure of the standard WACC approach simply stems from the fact that Eq. (2)1 is not consistent with Eqs. (8) and (9) in Millers paper. Eq. (2) serves to determine a stream of constant operating cash ows, using a projects WACC that is also assumed constant throughout the projects life. Unfortunately, this assumption is not consistent with the attempt to calculate constant cash ows for shareholders and bondholders in Eqs. (8) and (9). A constant WACC implicitly requires that the debt ratio also remains constant, which is not the case in Millers example. The reason is that, each year, the projects debt ratio must be dened with respect to the economic value2 of the project (i.e., the sum of the present values of its future cash ows), which represents the actual projects contribution to the rms debt capacity. Therefore, Miller should determine the debt repayment schedule so as to satisfy this debt ratio, which here does not lead to the payment of constant annuities to debtholders. In other words, it is not possible to maintain constant the projects debt ratio and, at the same time, pay a constant amount to each fund provider. 2. Millers example revisited To correct Millers example by using consistent assumptions, we successively adopt3 the following two alternatives: we retain the assumption that the projects WACC remains constant (i.e., the projects debt ratio remains constant) and we determine the corresponding debt and equity cash ows; we retain the assumption that the debt and equity cash ows are constant, and we determine the corresponding successive WACC values. The data are those used by Miller, with a zero tax rate. Note that debt nancing is available at a 6% interest rate and cost of equity is 12%. 2.1. First alternative: constant projects WACC Let us apply the rst alternative to Millers example, by assuming a constant debt ratio equal to 1/4. Eq. (3) gives the WACC value: 1 3 (0.06) + (0.12) = 0.105. 4 4 Eq. (2) serves to calculate a constant operating cash ow CF producing a zero net present value (NPV) for an investment of $200,000:
8

NPV = 0 = $200, 000 +


n=1

CF (1.105)n

CF = $38, 173.86.

The equation numbering is that used by Miller in his paper. Chambers, Harris and Pringle (1982) have shown that, with this assumption, the standard WACC method and the equity residual method (shareholders viewpoint) produce the same net present value. See also Linke and Kim (1974), Ben-Horim (1979) and Miles and Ezzell (1980, 1985) and many other authors since. The concept of a projects economic value has also a practical interest: it represents the minimum cash amount at which the rm is willing to sell its stake in the project. 3 To value a project, the key issue is to know if the rm undertaking this project targets a constant debt ratio (as 80% of rms do, according to Graham and Harvey (2001)). If such is the case, the projects value is obtained by discounting the projects operating cash ows at the rms constant WACC discount rate (computed with the rms target debt ratio). To determine the projects equity value by using the equity residual method, one must then consider a debt repayment schedule such that every year the projects debt ratio is equal to the rms target debt ratio (rst alternative in Section 2). Conversely, if the project is nanced with project nance (or is the sole project of the rm) with a predetermined stream of debt cash ows, then its equity value must be calculated with the equity residual method by considering this stream of debt cash ows. This stream implicitly denes a projects debt ratio that varies throughout time. The projects value can also be obtained by discounting the projects operating cash ows at the corresponding successive WACC values (second alternative in Section 2).
2

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Table 1 Projects economic value, outstanding debt, equity value and fund providers cash ows (in dollars) when the project debt ratio is maintained equal to 1/4 Year 0 1 2 3 4 5 6 7 8 Projects economic value 200,000 182,826.2 163,849.1 142,879.3 119,707.8 94,103.3 65,810.3 34,546.5 0 Amount of outstanding debt 50,000 45,706.5 40,962.3 35,719.8 29,927 23,525.8 16,452.6 8636.6 0 Payment to debtholders 7293.5 7486.7 7700.2 7936.1 8196.8 8484.8 8803.1 9154.8 Equity residual cash ow 150,000 30,880.4 30,687.2 30,473.7 30,237.8 29,977.1 29,689.1 29,370.8 29,019 Equity value 150,000 137,119.7 122,886.8 107,159.5 89,780.9 70,577.5 49,357.7 25,909.9 0

Let us denote Vn the economic value of the project under study at the end of year n, with V8 = 0 and for n = 0, 1, . . ., 7:
8

Vn =
k=n+1

$38, 173.86 1.105kn

Note that Vn can also be computed in a recursive way since: Vn = $38, 173.86 + Vn+1 . 1.105

To use the same WACC value throughout the 8 years implicitly requires maintaining the debt ratio equal to 1/4. Therefore, each year n, we must have: Bn = (1/4)Vn , where Bn denotes the value of outstanding debt at the end of year n. The whole amount (interest payment plus principal repayment) paid to the debtholders each year n is consequently: 1.06Bn1 Bn . The cash ow available for shareholders (i.e., the equity residual cash ow) each year n is $38, 173.86 (1.06Bn1 Bn ). The following recursive formula can therefore be used to calculate the value of the equity (i.e., the project value from the shareholders viewpoint) in year n, denoted En : En = $38, 173.86 (1.06Bn Bn+1 ) + En+1 1.12 for n = 0, 1, . . . , 7.

The numerical values thus obtained are indicated in Table 1. As stated above, the cash ows paid to the debtholders are not uniform throughout time. They increase, while the equity cash ows decrease. Note that a loan amounting to $50,000 in year 0 (i.e., one-fourth of the investment) is consistent with the target debt ratio of 1/4, since the investment is equal to V0 (as the projects net present value is zero). Additionally, as can be easily checked in Table 1, the use of a WACC correctly calculated results in the following property (well-known4 in corporate nance): each year, the economic value of the project is equal to the sum of the equity value and the amount of outstanding debt. In other terms, if, at a given point in time, the rm sells an asset at a market price equal to its economic value, then what is left once the loan is reimbursed represents the amount of cash available for the shareholders.

For a proof of this property, see for instance Chambers et al. (1982).

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2.2. Second alternative: constant debt and equity cash ows The constant equity residual cash ow CFe and debt cash ow CFd are given by Eqs. (8) and (9) respectively:
8

NPV = 0 = $150, 000 +


T =1 8

CFe (1.12)T CFd

CFe = $30, 195.43,

NPV = 0 = $50, 000 +


T =1

(1.06)T

CFd = $8051.80.

By adding CFe and CFd we obtain a constant operating cash ow equal to $38,247.23. Note that this operating cash ow is not equal to that computed with the rst alternative (since the underlying assumptions are different). By again using recursive formulas, we have therefore: $30, 195.43 + En+1 1.12 $8, 051.80 + Bn+1 1.06

En = Bn =

for n = 0, 1, . . . , 7, with E8 = 0, for n = 0, 1, . . . , 7, with B8 = 0,

where En and Bn respectively denote the equity value and the amount of outstanding debt at the end of year n. The WACC value to use for year n + 1 is equal to: Bn En 0.12 + 0.06. En + Bn En + Bn By denoting Vn the projects economic value at the end of year n, we have Vn = $38, 247.23 + Vn+1 1 + ((En /(En + Bn )) 0.12 + (Bn /(En + Bn )) 0.06) for n = 0, 1, . . . , 7, with V8 = 0.

The projects economic value, the amount of outstanding debt, the equity value and the WACC value, computed with these recursive formulas, are given for every year in Table 2. Again, each year, the projects economic value is equal to the sum of the equity value and the amount of outstanding debt.

Table 2 Projects economic value, outstanding debt, equity value (in dollars) and WACC value when the debt and equity cash ows remain constant Year 0 1 2 3 4 5 6 7 8 Projects economic value 200,000 182,752.8 163,739.0 142,764.9 119,614.4 94,046.9 65,793.9 34,556.2 0 Amount of outstanding debt 50,000 44,948.2 39,593.3 33,917.1 27,900.3 21,522.6 14,762.1 7596.0 0 Equity value 150,000 137,804.6 124,145.7 108,847.8 91,714.1 72,524.3 51,031.8 26,960.2 0 WACC value 0.1050 0.1052 0.1055 0.1057 0.1060 0.1063 0.1065 0.1068

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2.3. Irrelevance of Millers modied WACC The modied WACC value suggested by Miller, dened by Eq. (23), is here equal to 10.5533%. This is determined by (arbitrarily5 ) assuming constant debt and equity cash ows (see Eqs. (13), (16) and (19)). Obviously, the projects economic values calculated for years 17 using this modied WACC would differ from those indicated in Table 2. Therefore, the projects value calculated for every year of the projects lifetime with this modied WACC is not equal to the sum of the corresponding debt and equity values. This inconsistency shows the irrelevance of Millers modied WACC. In fact, Eq. (23) just gives the value of the internal rate of return yielded by the sum of two streams of constant cash ows as a function of the internal rates of return that both cash ow streams yield separately. Acknowledgement The author gratefully acknowledges helpful comments by one anonymous referee. References
Ben-Horim, M. (1979). Comment on the weighted average cost of capital as a cutoff rate. Financial Management, 8, 1821. Chambers, D. R., Harris, R. S., & Pringle, J. J. (1982). Treatment of nancing mix in analyzing investment opportunities. Financial Management, 8, 2441. Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate nance: Evidence from the eld. Journal of Financial Economics, 60, 187243. Linke, C. M., & Kim, M. K. (1974). More on the weighted average cost of capital: A comment and analysis. Journal of Financial and Quantitative Analysis, 9, 10691080. Miles, J., & Ezzell, J. R. (1980). The weighted average cost of capital, perfect capital markets and project life: A clarication. Journal of Financial and Quantitative Analysis, 15, 719730. Miles, J., & Ezzell, J. R. (1985). Reformulating tax shield valuation: A note. The Journal of Finance, 40, 14851492. Miller, R. A. (2009). The weighted average cost of capital is not quite right. The Quarterly Review of Economics and Finance, 49, 128138.

5 To assume constant debt and equity cash ows amounts to imposing a special pattern of operating cash ows for the project. Moreover, a constant debtcash ow schedule, over the entire projects lifetime, is far from being the sole realistic assumption: to repay a loan, a rm can use other predetermined schedules (constant principal repayment schedule, as-fast-as-possible repayment schedule, etc.) over a shorter period. Anyway, to design a special counter-example if it were correct would be sufcient to disqualify the WACC as a general rule, but not to produce a general modied WACC formula (as Miller tries to do).

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