Wacc is Not an Expected Return of the Levered Firm

Abstract

The model of Modigliani and Miller is one of the cornerstones of modern finance. In their model a tax system generates advantages from debt financing that can be valued using the weighted average cost of capital. Although widely used the concept of cost of capital is usually loosly defined: we provide a simple binomial model showing the counterintuitive result that these cost of capital cannot be interpreted as expected returns of the levered firm.

Keywords: cost of capital, capital budgeting

JEL Classification: G31, D46