The Miles & Ezzell (M & E) WACC Reconsidered

34 Pages Posted: 4 Feb 2002  

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy

Andreas Loeffler

Freie Universität Berlin

Date Written: January 2002

Abstract

In a recent paper, Loeffler (2001) showed that the Miles & Ezzell (M & E) WACC allows arbitrage if the cash flow process does not have a "certain growth rate". To be specific, for a particular period, the set of up and down coefficients must be the same at all the nodes in a binomial cash flow process.

In this teaching note, we use simple three period numerical examples to illustrate the calculations of the WACC for cash flow processes that satisfy and violate the growth rate assumption. The note is organized as follows. In Section One, we present a simple three period binomial cash flow process S with multiplicative coefficients that satisfy the growth rate assumption. We calculate the unlevered value with two equivalent methods. One approach uses the risk-neutral probabilities and the risk-free rate. The other approach uses the objective probabilities that are consistent with the risk-neutral probabilities and the return to unlevered equity.

In Section Two, we introduce debt and calculate the levered values with the same two methods. Since process S satisfies the growth rate assumption, we verify that the WACCME does not allow arbitrage.

In Section Three, with a simple modification, we create a new binomial cash flow process that violates the growth rate assumption and show that the WACCME allows arbitrage.

Keywords: Risk-neutral valuation, WACC Theory

JEL Classification: D61, G31, H43

Suggested Citation

Tham, Joseph and Loeffler, Andreas, The Miles & Ezzell (M & E) WACC Reconsidered (January 2002). Available at SSRN: https://ssrn.com/abstract=298599 or http://dx.doi.org/10.2139/ssrn.298599

Joseph Tham (Contact Author)

Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )

Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)

HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx

Andreas Loeffler

Freie Universität Berlin ( email )

Boltzmannstr. 20
Berlin, 14195
Germany

HOME PAGE: http://www.andreasloeffler.de

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