15 Pages Posted: 9 Oct 2001
Date Written: December 2001
A simple counterexample shows that the WACC formula developed by Miles and Ezzell can be used to create an arbitrage opportunity. The only consequence to be drawn is that their WACC approach cannot be applied under the circumstances assumed by Miles and Ezzell. We show how the WACC theory has to be modified in order to obtain proper results. We develop a theory in continuous as well as discrete time. In discrete time it turns out that with a further assumption on the cash flows of the firm formulas similar to Miles and Ezzell's results can be verified. This assumption requires that the increment of cash flows has conditional expectation proportional to the current cash flow. This condition can be interpreted as a discrete time analog of a Brownian motion.
Keywords: WACC, leverage ratio, tax shield
JEL Classification: G31, H34
Suggested Citation: Suggested Citation