On the Correct Evaluation of Cost of Capital for Project Valuation

Abstract

This paper fills a very important gap in the literature with a straightforward methodology that generalizes the classic Modigliani and Miller results and provides correct values for the expected return on equity and for the weighted average cost of capital (WACC). After some confusing debate in the literature, we show that these correct values make the three main project valuation approaches (WACC, flow to equity and adjusted present value) to perfectly match. Specifically, we show that the expected return on equity for finite horizon projects will be horizon dependent, which means that it will (sometimes drastically) change as the project life shortens even when all other variables remain constant (e.g., the leverage ratio). Obviously, this result will directly affect the WACC. Another interesting result is that the traditional textbook formula for the WACC is not always correct, even for perpetual projects.

Keywords: Cost of Capital. Project Valuation. WACC

JEL Classification: G11, G31