There Exists Circularity between WACC and Value? Another Solution

Estudios Gerenciales, Vol. 98, pp. 13-23, January-March 2006

11 Pages Posted: 13 Nov 2005 Last revised: 26 Jun 2012

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Julián Benavides Franco

Universidad ICESI - Finance; Universidad ICESI - Economics & Management

Date Written: November 12, 2005

Abstract

Although we know there exists a simple approach to solve the circularity between value and the discount rate, known as the Adjusted Present Value proposed by Myers, 1974, it seems that practitioners still rely on the traditional Weighted Average Cost of Capital, WACC approach of weighting the cost of debt, Kd and the cost of equity, Ke and discounting the Free Cash Flow, FCF. We show how to solve circularity when calculating value with the free cash flow, FCF and the WACC. As a result of the solution we arrive at a known solution when we assume the discount rate of the tax savings as Ke, the cost of unlevered equity: the capital cash flow, CCF discounted at Ku. When assuming Kd as the discount rate for the tax savings, we find an expression for calculating value that does not implies circularity. We do this for a single period and for N periods.

Keywords: Firm valuation, cost of capital, cash flows, free cash flow, capital cash flow, WACC, circularity

JEL Classification: M21, M41, G12, G31, J33

Suggested Citation

Velez-Pareja, Ignacio and Benavides Franco, Julián, There Exists Circularity between WACC and Value? Another Solution (November 12, 2005). Estudios Gerenciales, Vol. 98, pp. 13-23, January-March 2006. Available at SSRN: https://ssrn.com/abstract=846804

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

Julián Benavides Franco

Universidad ICESI - Finance ( email )

Calle 18 #122-135
A.A. 25608
A.A. 25608 Cali
Colombia

Universidad ICESI - Economics & Management ( email )

Cali
Colombia

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