Proper Solution of Circularity in the Interactions of Corporate Financing and Investment Decisions: A Reply to the Financing Present Value Approach
Management Research News, Vol. 28, No. 10, pp. 65-92, January 2005
Posted: 16 May 2006
It is a well known problem the interactions between the market value of cash flows and the discount rate (usually the weighted average cost of capital, WACC) to calculate that value. This is mentioned in almost all textbooks in corporate finance. However, the solution adopted by most authors is to assume a constant leverage D%, and hence assume that the leverage gives raise to an optimal capital structure and the discount rate is constant.
On the other hand, most authors use the definition of the Ke, the cost of leveraged equity for perpetuities even if the planning horizon is finite. Among these authors we find the work of Wood and Leitch W&L 2004.
In this paper we wish to analyze the claim made by W&L 2004 in the sense to have found an iterative solution to the problem of circularity that results in a near matching with the Adjusted Present Value APV, proposed by Myers, 1974. They use as the basic principle the fact that there is a near constant relation between Ke the cost of equity and Kd the cost of debt. They consider as well that the cost of debt Kd is not constant and changes proportionately with the leverage D%.
We propose a very simple and precise approach to solve the above mentioned circularity problem.
Keywords: Adjusted Present Value, APV, weighted average cost of capital, circularity problem, discounted cash flow, DCF equity value, cost of equity
JEL Classification: G30, G31, G32
Suggested Citation: Suggested Citation