Constant Leverage And Constant Cost Of Capital: A Common Knowledge Half-Truth
AbstractA typical approach for valuing finite cash flows is to assume that leverage is constant (usually as target leverage) and the cost of equity, Ke and the Weighted Average Cost of Capital, WACC are also assumed to be constant. For cash flows in perpetuity, and with the cost of debt, Kd as the discount rate for the tax shield, it is indeed the case that the Ke and WACC applied to the FCF are constant if the leverage is constant. However this does not hold true for finite cash flows. In this document we show that for finite cash flows, Ke and hence WACC depend on the discount rate that is used to value the tax shield, TS and as expected, Ke and WACC are not constant with Kd as the discount rate for the tax shield, even if the leverage is constant. We illustrate this situation with a simple example. We analyze five methods: DCF using APV, FCF and traditional and general formulation for WACC, present value of CFE plus debt and Capital Cash Flow, CCF.
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Bibliographic InfoArticle provided by UNIVERSIDAD ICESI in its journal ESTUDIOS GERENCIALES.
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WACC; constant cost of capital; constant leverage; cash flows;
Other versions of this item:
- Ignacio Velez-Pareja & Rauf Ibragimov & Joseph Tham, 2007. "Constant leverage and constant cost of capital: a common knowledge half-truth," PROYECCIONES FINANCIERAS Y VALORACION 003939, MASTER CONSULTORES.
- D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ignacio Velez-Pareja & Joseph Tham, 2000. "A Note on the Weighted Average Cost of Capital WACC," PROYECCIONES FINANCIERAS Y VALORACION 001926, MASTER CONSULTORES.
- Robert A. Taggart & Jr., 1991. "Consistent valuation and Cost of Capital Expressions With Corporate and Personal Taxes," Financial Management, Financial Management Association, vol. 20(3), Fall.
- Ignacio Vélez-Pareja, 2004. "Modeling the Financial Impact of Regulatory Policy: Practical Recommendations and Suggestions. The Case of World Bank," PROYECCIONES FINANCIERAS Y VALORACION 003228, MASTER CONSULTORES.
- Ignacio Velez-Pareja & Joseph Tham, 2008. "Constant leverage modeling: A reply to "A tutorial to the Mckinsey model for valuation of companies"," PROYECCIONES FINANCIERAS Y VALORACION 004574, MASTER CONSULTORES.
- Ignacio Vélez-Pareja & Antonio Burbano, 2005. "Consistency in Valuation: A Practical Guide," PROYECCIONES FINANCIERAS Y VALORACION 002192, MASTER CONSULTORES.
- Ignacio Vélez-Pareja & Joseph Tham, 2004. "Consistency in Chocolate. A Fresh Look at Copeland’s Hershey Foods & Co Case," PROYECCIONES FINANCIERAS Y VALORACION 002191, MASTER CONSULTORES.
- Ignacio Vélez-Pareja & Joseph Tham, 2006.
"An Embarrassment of Riches: Winning Ways to Value with the WACC,"
Economic Analysis Working Papers (2002-2010). Atlantic Review of Economics (2011-2013),
Colexio de Economistas de A Coruña, Spain and Fundación Una Galicia Moderna, vol. 5, pages 1-23, February.
- Joseph Tham & Ignacio Velez-Pareja, 2002. "An Embarrassment of Riches: Winning Ways to Value with the WACC," PROYECCIONES FINANCIERAS Y VALORACION 001974, MASTER CONSULTORES.
- Ignacio Velez-Pareja, 2007.
"Which cost of debt should be used in forecasting cash flows?,"
PROYECCIONES FINANCIERAS Y VALORACION
004318, MASTER CONSULTORES.
- Ignacio Vélez-Pareja, 2009. "Which Cost Of Debt Should Be Used In Forecasting Cash Flows?," ESTUDIOS GERENCIALES, UNIVERSIDAD ICESI.
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