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Constant Leverage And Constant Cost Of Capital: A Common Knowledge Half-Truth

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A 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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Article provided by UNIVERSIDAD ICESI in its journal ESTUDIOS GERENCIALES.

Volume (Year): (2008)
Issue (Month): (June)

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Handle: RePEc:col:000129:005012
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  1. 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.
  2. 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.
  3. 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 (2011-2016), Colexio de Economistas de A Coruña, Spain and Fundación Una Galicia Moderna, vol. 5, pages 1-23, February.
  4. Fernandez, Pablo, 2002. "Valuation Methods and Shareholder Value Creation," Elsevier Monographs, Elsevier, edition 1, number 9780122538414.
  5. 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.
  6. Ignacio Vélez-Pareja & Antonio Burbano, 2005. "Consistency in Valuation: A Practical Guide," PROYECCIONES FINANCIERAS Y VALORACION 002192, MASTER CONSULTORES.
  7. Ignacio Velez-Pareja & Joseph Tham, 2000. "A Note on the Weighted Average Cost of Capital WACC," PROYECCIONES FINANCIERAS Y VALORACION 001926, MASTER CONSULTORES.
  8. 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.
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