On the Theoretical Foundation of Corporate Finance
16 Pages Posted: 15 Oct 2020
Date Written: August 26, 2020
Modigliani and Miller theory forms the theoretical foundation of corporate finance. Yet Modigliani and Miller theory was derived from a very special case of cash flows. Weighted Average Cost of Capital (WACC), which is part of the Modigliani and Miller theory, plays a fundamental role in capital structure decision and asset valuation. In practice, asset valuation calculated from cash flows discounted by WACC almost always differs from the sum of debt and equity values. We derive asset valuations for more general cashflows. Only when the debt equity ratio is constant over time, valuation by WACC is equal to the sum of debt and equity values.
Keywords: WACC, Modigliani and Miller theory, asset valuation
JEL Classification: G12, G30, G32
Suggested Citation: Suggested Citation