IDEAS home Printed from https://ideas.repec.org/a/cup/jfinqa/v15y1980i03p719-730_00.html
   My bibliography  Save this article

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

Author

Listed:
  • Miles, James A.
  • Ezzell, John R.

Abstract

For financial management to make wealth maximizing capital budgeting decisions, a model that will determine correctly the market value of a project's levered cash flows is required. A capital budgeting model should account not only for the effects of the investment decision, but also for the effects of the financing decision and the interactions between the two decisions. In perfect capital markets all the effects of the financing decision pertain to the tax shield created by debt financing. Thus, as originally shown by Modigliani and Miller [8], the value of a project's levered cash flow stream equals the market value the stream would have if it were unlevered plus the market value of the stream of tax savings on interest payments associated with the debt employed to finance the project. While this result is completely general with respect to the specific processes utilized by the market to value the two components, MM specified the value of the unlevered component as the present value of the unlevered cash flows discounted at the appropriate risk adjusted unlevered cost of capital and they specified the value of the tax savings component as the present value of the tax shield on interest discounted at the cost of debt. Accordingly, the value of a project's levered cash flows is specified as the sum of these two present values, one representing the effects of the investment decision and the other capturing the effects of the financing decision. The MM valuation model has been extended to normative capital budgeting analysis by Myers [9] in terms of the adjusted present value (APV) model.

Suggested Citation

  • Miles, James A. & Ezzell, John R., 1980. "The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(3), pages 719-730, September.
  • Handle: RePEc:cup:jfinqa:v:15:y:1980:i:03:p:719-730_00
    as

    Download full text from publisher

    File URL: https://www.cambridge.org/core/product/identifier/S0022109000006566/type/journal_article
    File Function: link to article abstract page
    Download Restriction: no

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cup:jfinqa:v:15:y:1980:i:03:p:719-730_00. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Keith Waters). General contact details of provider: https://www.cambridge.org/jfq .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.