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ing the WACC for investment decisions need to be fully aware of its pit-
falls and misuses.
INTRODUCTION
REVIEW
The interactions between the market value of cash flows and the dis-
count rate (usually the WACC) used to calculate the leveraged value is a
well known problem. (See Myers, 1974). It is mentioned in almost all
the textbooks on corporate finance. However, the typical solution of-
fered by most authors is to assume a constant discount rate which im-
plies a constant leverage D%, and hence to assume that the constant
leverage corresponds to an optimal capital structure. 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 au-
thors we find the work of Wood and Leitch (W&L, 2004). Vélez-Pareja
and Tham (2005), however, contest the work of Wood and Leitch.
Vélez-Pareja and Tham (2000), Tham and Velez-Pareja (2002),
Vélez-Pareja and Burbano (2005), Tham and Velez-Pareja (2004b), and
Velez-Pareja and Tham (2005) have shown and proposed a very simple
manner for tackling the issue of circularity. Mohanti (2003) proposes an
iterative method to solve the issue. Wood and Leitch (W&L, 2004) pro-
pose an iterative and approximate method to solve circularity.
When we review the literature on this subject we find that either the
authors avoid the problem of matching the results using different meth-
ods, or they use perpetuities (a way to avoid the problem), or they use a
very simple example (one period), or they say simply that differences
are not relevant. Taggart (1991), Vélez-Pareja and Tham (2000), Tham
and Velez-Pareja (2002), Vélez-Pareja and Burbano (2005) and Tham
and Velez-Pareja (2004a and 2004b) have derived independently the
expression for Ke when there are finite cash flows.
In the best reputed textbook on corporate finance (Brealy, Myers and
Allen (BMA) 2006, 8th edition), in referring to an example with finite
cash flows where APV and FCF methods do not match, the authors state
(BMA, 2006, page 523):
“. . . If the debt levels are taken as fixed, then the tax shields should
be discounted back at the 6 percent borrowing rate.
[. . .] The increase [in value] can be traced to the higher early debt
levels and to the assumption that the debt levels and interest tax
shields are relatively safe.” (There is a foot note that says: “But
will Rio really support debt shown [. . .]? If not, then the debt must
be partially supported by Sangria’s [the firm that would buy Rio]
M. A. Mian and Ignacio VUlez-Pareja 23
In Vélez-Pareja and Tham (2006), the authors show that the two
methods give identical results using the same example proposed by
BMA.
Ross, Westerfield and Jaffre (RWJ, 1999, p. 441), referring to three
methods to calculate the leveraged value of a firm for perpetuity, state:
“The net present value [. . .] is exactly the same under each of the
three methods [PV(FCF at WACC, PV(ECF at Ke) + debt and Ad-
justed present value, APV]. However, one method usually pro-
vides an easier computation than another, and, in many cases, one
or more of the methods are virtually impossible computationally.
[. . .]
Copeland, Koller and Murrin (2000, p. 148) state: “You may have
noted that the enterprise value of operations does not exactly match that
given by the APV approach. The difference is about 2 percent. The en-
24 LATIN AMERICAN BUSINESS REVIEW
terprise DCF model assumes that the capital structure (the ratio of debt
to debt plus equity in market values) and WACC would be constant ev-
ery period. Actually the capital structure changes every year.”
When the values of equity under different methods do not match,
Benninga (1997 p. 418) states: “As you can see, the results of the two
valuations are very close. The differences are caused by the fact that we
have used cost of capital formulas for no-growth, infinitely lived mod-
els to do the valuation job in our pro-forma framework, in which cash
flows are projected to grow.”
We have mentioned the most popular books on valuation and we can
see that either they do not solve the problem of matching the values un-
der different methods or they simply avoid it. In this paper, we show
how to actually solve the problem and we show that the matching of val-
ues calculated under different methods is possible and very easy to do.
The reason for defining various cash flow streams is that there is an
interrelationship between the type of cash flow and the corresponding
WACC. The difference between the various cash flows is found solely
in their treatment of the value of leverage. This is a very crucial point,
which is always overlooked. This point has significant implications
with respect to the definitions of the cost of capital, cost of equity, and
cost of debt. Ignoring this point leads to considerable confusion and po-
tential errors in applying the discounted cash flow concept. In fact, this
is where most analysts violate the assumptions on which the discounted
cash flow concept is based, and thus start misusing it.
The most straightforward and intuitive way to see the differences is
to numerically specify a particular cash flow with its respective cost of
capital, and then compare the resulting profitability yardsticks from the
various cash flow streams. Some of the most commonly encountered
cash flows in text books and journals are, according to Ruback (1995):
FCF (Free Cash Flow)–as shown in Table 2, FCF assumes a hypo-
thetical all equity capital structure, i.e., total net cash flow–no disburse-
ment of interest and principal payments to debt holders. The interest and
principal payments and tax benefits due to deductible interest payments
are incorporated in the discount rate (after-tax weighted average cost of
capital, WACCAT) rather than the cash flow. It comprises the funds
available for distribution and funds actually distributed in the portfolio
of all the company’s securities.
ECF (Equity Cash Flow)–includes debt payments (principal and in-
terest) to debt holders. The resulting cash flow, as shown in Table 3, is
net to the Equity shareholders. This is the classic cash flow and portrays
a true image of the cash balance in the company’s account. Since the
debt cash flows are included in the cash flow, the cost of equity (KE)
rather than the WACCAT is used for discounting. Or the other way
around, it is the cash flow left over from the FCF after the debt holders
are paid off.
CFD (Cash Flow to Debt holders)–Loan proceeds and Interest and
principal payments to the debt holders on the outstanding debt.
CCF (Capital Cash Flow)–cash flow available to both equity and
debt holders. As shown in Table 4, this includes only the tax benefit of
tax deductible interest. Since the tax benefit is included in the cash flow,
the before-tax weighted average cost of capital (WACCBT) is used for
discounting. Or the other way around, it is what the portfolio of all the
M. A. Mian and Ignacio VUlez-Pareja 27
Table 5 summarizes the types of cash flow and the corresponding dis-
count rate to be used.
no, not at all. Similarly, all other profitability indicators will be differ-
ent. The FCF is equal to the after-tax cash flow of an otherwise identical
project with no debt. The IRR reflects the return on equity; it has to be
calculated with the ECF.
Besides the interrelationship between the cash flows and WACC, the
approach is based on the following assumptions (see Tham and Vélez-
Pareja (2004), Vélez-Pareja and Tham (2000) and Vélez-Pareja and
Burbano, (2005)).
1. The D/V ratio is based on the market value of the investment and
not the book value. The market value of equity and the market value of
debt refer respectively to the equity and debt proportion of the market
value (V) of the firm so that WE + WD = 100%.
The market value is the discounted value (discounted at the WACCAT)
of the FCF. Therefore, V is not the book value, the amount invested, or
the project cost as it is most commonly interpreted. This is a very crucial
assumption of the WACC concept. The market value of debt and the
corresponding interest and principal payments (CFD) for the cash flow
in Table 3 are calculated as shown in Table 6.
The constant D/V ratio does not fit well with observed practice and/
or may be difficult to maintain. Firms more typically manage issue
amounts and repayment schedules, and would find it very difficult to
maintain a constant debt ratio in a world of changing equity values (see
Vélez-Pareja and Tham (2005) and Tham and Vélez-Pareja, (2005)).
30 LATIN AMERICAN BUSINESS REVIEW
The above discussion dealt with textbook cases of the classic WACC
concept. However, in practice the execution of this concept becomes
even more complicated and restricted. Over the years since the incep-
M. A. Mian and Ignacio VUlez-Pareja 31
TABLE 7. Match Between CCF, CFD and ECF (Proof of Assumptions 7 and 8)
As shown above, the difference in the NPV from one method to the
other is due to the violation of the assumptions on which the WACC
34 LATIN AMERICAN BUSINESS REVIEW
rate in order to arrive at the NPV. It is worth noting that all four
methods calculate an identical NPV of $92.5. The methods used
to arrive at the NPVs in Table 12 are described as follows.
(3)
CONCLUDING REMARKS
The above analyses prove that the only compelling virtue for advo-
cating the use of the classic WACC equation [as shown in Equation (1)]
is that it requires a simplified cash flow. This property, of course, could
TABLE 12. Alternative Approaches to Calculating NPV
37
38 LATIN AMERICAN BUSINESS REVIEW
NOTE
1. The reader should realize that in the context of this paper we have assumed that
, the discount rate for the ITS, is Ku, the cost of unlevered equity.
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