The One and Only Standard WACC - Cost of Capital versus Return on Capital
31 Pages Posted: 15 Jul 2005 Last revised: 10 Jun 2016
Date Written: September 22, 2014
A lot of finance textbooks present calculation of WACC (Weighted Average Cost of Capital) as: WACC = Kd - (1 -/- T)- D % Ke - E %, whereas Kd is opportunity cost of debt before taxes, T is tax rate, D % is percentage of debt to total value, Ke is opportunity cost of equity and E % is percentage of equity to total value. Numerous textbooks state that D % and E % are market values, but the correct interpretation of these values is not sufficiently dealt with: which market values, what D/E-ratio? No matter how the financing is done, there is actually only one standard net WACC.
WACC changes in time, one needs an up-to-date WACC, yes indeed, but what and how exactly? In short, many questions still remain, but up to the present they do not have unequivocal answers. The purpose of this paper is to clear up these questions and emphasize in some ideas that usually are overlooked. Famous writers, e.g., Pablo Fernandez, Ignacio Velez-Pareja and Joseph Tham, claim: to calculate the firm's value it is necessary to know the WACC-figure, but to calculate WACC, the firm's value (among other data like the financing profile) is needed. Indeed, one needs to know the WACC in order to calculate the firm's value. However, to calculate WACC, several data are truly needed, just not the firm's value. Many misconceptions exist about firm valuation and the valuation of tax shields (VTS) as well as the correct calculation of WACC.
Although Franco Modigliani and Merton Miller (MM for short) were awarded the Nobel Prize in Economics, their Propositions I and II appear to be clearly incorrect. Many theories and much advise is flawed by the demasque of MM's Proposition I (1958, equation 3), which states in the absence of taxes, the firm's value is independent of its debt. The so-called proof given by MM is not a mathematical proof. It was and is a statement that cannot stand the test. Proposition I is not true; re SSRN_ID609102. Consequently, everything based on Proposition I is not true either. This paper repudiates Proposition II, constituting Ke being a cost to the firm and similarly a return to the equity investor. Ke and WACC are measuring costs, just costs. Return and cost values coincide at intersect-points only of clearly divergent return and respectively cost functions.
Keywords: Weighted Average Cost of Capital (WACC), firm valuation, capital budgeting, cost of equity, cost of debt, Return On Assets (ROA), Return On Equity (ROE), standard D/E mix
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