The Weighted Average Cost of Capital as a Cutoff Rate: A Critical Analysis of the Classical

Textbook Weighted Average

Author(s): Fred D. Arditti and Haim Levy
Source: Financial Management, Vol. 6, No. 3 (Autumn, 1977), pp. 24-34
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665253
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 The Weighted Average Cost of Capital
as a Cutoff Rate: A Critical Analysis of the
Classical Textbook Weighted Average

Fred D. Arditti and Haim Levy

Fred D. Arditti is Professor of Finance and Economics at the

University of Florida at Gainesville. Haim Levy is Professor of
Finance at the Hebrew University of Jerusalem, Israel.

Introduction mistakes do not cancel, and the textbook procedure

leads the firm to an incorrect decision.
Assuming that the firm has an optimal debt/equityThe traditional weighted average post-tax cost of
ratio, most textbooks recommend using the weighted
capital - presented in leading textbooks (cf. [4], [1I],
average cost of capital as a cutoff rate for investment
and [12]) and taught in most courses, including those
decision-making. Arditti [1] demonstrates that taught
the by the authors of this paper - we denote as ct,
components of the weighted after-tax cost of capital,
defined as
as recommended by most textbooks, have been in-
correctly specified. This misspecification implies that ct = rt (S/V) + (1 - t) i (D/V) (1)
the capital structure that minimizes the weighted where rt, i, t, S and D, respectively, symbolize the
average after-tax cost of capital is a non-optimal one.
post-tax required or expected rate of return on the
In this paper we extend Arditti's argument firm's
and equity market value, the interest rate on out-
demonstrate that the finance textbooks' traditional
standing debt, the corporate tax rate, and the market
post-tax cash flow can be misleading. Basically, there
values of the firm's total equity and total debt. Note
are two mistakes in these texts: one in defining the that rt is the value which solves the equation S =
project's cash flow and one in defining the cost of
capital. While these two mistakes may offset each where dj is the dividend paid in year j.
J - 1 (1 + rt)
other in some cases, therefore presenting the firm with
the correct accept-reject decision, generally the two
Since dividends are paid after paying corporate tax, rt

24

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 F. D. ARDITTI AND H. LEVY/THE WEIGHTED AVERAGE COST OF CAPITAL 25

when used in the above-mentioned textbooks is the The Correct Weighted Average
post-tax cost of equity. The pre-tax cost of equity r Cost of Capital
and the post-tax rt are related to each other according
to the following formula:
Pre-Tax Analysis

rt = (I - t)r If the firm expects to earn and distribute X every

year, and the market value of the firm is V = S+D,
In our discussion (as in Modigliani and Miller's then c, the pre-tax weighted average cost of capital, is
model [8]), the firm pays out all its cash flow as given by
dividends and interest. Therefore, if the firm expects
to earn every year X dollars, it pays iD to the bond-
c = X/V, (3)

holders and X - iD as dividends. The pre-tax cost of or equivalently

equity is given by the value r which solves
c = r(S/V) + i(D/V), (3a)

S X-iD X-iD arrived at by substituting X = (X - iD) + iD for X in

S= .=
j= 1 (1+ r)j r Equation (3) as follows,
(X - iD) S iD X - iD
and the post-tax cost of equity rt is given by c : v ( S ) V v S(
co (1-t)(X - iD) (1 - t)(X - iD) ( )+ i()
= 1 ( + rt)j rt
and be
Hence rt = (1 - t)r. It should recognizing
mentioned(X that
- iD)/S as r
most
textbooks use the dividendSo far there
model is no problem,
in deriving and th
the cost
average cost
of equity, i.e., they apply directly of capitalrequired
the post-tax as stated
rate of return, rt. (3a) and used in most textbooks
Using the above relationship between r and rt Equa-
tion (1) can be rewritten Post-Tax
as Analysis

ct = (1 - t)r(S/V) +Post-tax evaluation

(1 - t)i(D/V). of the pr
(la)
relevant framework from a theore
We claim that the cutoff rate
tical defined
point of by Equations
view. Hence we(1)
dev
or (la) is conceptually wrong and in practice may lead
paper to the post-tax case.
to a non-optimal decision.The In discount
proving our
rate claim,
applied we f
to the
assume that the firm's capital structure remains con-
tax expected cash flows we symbol
stant over time. Since this
by, same assumption underlies
the traditional application of the weighted average
V = X/c*
cost of capital, the conclusions of this (4)
paper are rele-
vant.
or
In the next section of this paper, we deduce that the
correct weighted average cost of capital, c* is given by c* = Xt/V. (4a)

Since Xt = (X - iD) (1 -t) + iD, then

c* = rt(S/V) + i(D/V) (2)
c* (X-iD)(l-t) S +i ( D
or ct- s (V) + (v ) (5)

c* = (1 -t)r(S/V) + i(D/V). (2a) or

Although this paper is mainly normative, one can

c* = r(l -t)(S/V) + i(D/V). (6)
also test the behavior of firms and analyze the In order to have a better comparison of Equation (6)
accepted and rejected projects according to the with textbook-suggested cost of capital, the equation
suggested rule vs. the textbook-suggested procedure. can be rewritten as
We will show that, in most cases, using Equation (1)
rather than (2) will lead the firm to errors in the invest- c* = rt(S/V) + i(D/V) (6a)
ment decision-making. Equation (6) is derived for the perpetuity case. The

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26 FINANCIAL MANAGEMENT/FALL 1977

same formula holds for the finite case, however, as Equation (2)), should be used. That c* > ct is easily
long as the capital structure is kept unchanged. For seen by comparing Equations (1) and (2) and noting
example, suppose that the firm expects to earn and that c* - ct = ti(D/V). This difference arises from the
distribute, as before, X every year for n years but different post-tax cost of debt components used in the
plans to sell its assets after n years (without liquida- two formulas.
tion cost) and to pay the stockholders S and the bond- We do not deny that debt carries an income
holders D. Recall that according to this model the generating advantage over equity due to the tax de-
value of the firm at the beginning of each year is ex- ductibility of interest. However, we disagree with the
pected to be V. Thus, the value of the firm in the finite practice of lowering the cost of debt component in the
case, is given by weighted average cost of capital formula by these tax
savings of ti(D/V) as Equation (1) does, because these
n Rt V
V= 2 + savings have already been accounted for in the cost of
j (l+ *)i (l + c*) equity calculation. Consequently, to also reduce the
or cost of debt by such savings is to count them double in
constructing the cost of capital figure.
To clarify our contention, consider the following
C* 1 + c* (1 + c*) numerical example. Assume that interest is not tax
Hence, also in this case deductible, and that X = 100, iD = 10 and t = .5.
What is the maximum annual total dividend payment
1 Xt that shareholders may expect? Since iD is assumed to
V[1- ( n =
11 vl c* c-, [1 ( 1 cl
I + + C* )"]
be non-deductible, the answer is found by computing (1
and hence V = Xt/c*. - t)X - iD, which is 40. Now take a turn towards
reality and allow it to be deductible. Then the max-
The same analysis derived from Equation (4) holdsimum expected dividend is found by computing X -
also in the finite case.
t(X - iD) - iD which is 45. Since this is precisely how
Another way to look at the finite case is as follows the market would compute the firm's expected divi-
(we demonstrate the pre-tax case): suppose that the dend stream, we see that the presence of interest tax
firm pays out annually as interest and dividends anddeductibility raises the expected dividend payment.
also a part of the bonds principal not only X but also
Since the post-tax cost of equity, symbolized by rt
Dp, where Dp is the annual economic depreciation. X(and equal to r(l - t) in the perpetuity case), is defined
+ Dp is divided between stockholders and bond-by
holders in such a way that the capital structure is kept
unchanged. Thus, the firm is decreasing in scale every
S- dj (7)
S=Z+
year without changing its economic risk. The value of
j=l (Il-rt)j
the firm is V, when where dj is the expected dividend payment in year j, we
see that by raising dj, interest tax deductibility affects
V= D (1 -( )n]. l+c rt. (Recall that the S value is given, and we are wholly
concerned with the technical problem of calculating
But since the economic depreciation is defined as the the correct relationship between post-tax and pre-tax
amount of dollars which if invested for n years cost of funds figures.) The above indicates that the tax
guarantees continuation of the same level of cash flow, advantages of debt have been accounted for in the cost
i.e., Dp(l + c)n = X + Dp, we obtain that VI = V = of equity capital. Is it legitimate to again count the tax
X/c. advantage of debt when calculating the cost of debt?
Note that we assume throughout the paper that Our point can be made easily in a more formal
dividend policy is irrelevant (see Equation (7)). Hence, manner if we consider an expected earnings stream
the firm may decide instead of paying an infinite that is a perpetuity. We have already observed that the
stream of dividends to pay a finite stream (with larger post-tax expected rate of return on equity when in-
annual dividends). This new dividend policy has no terest is tax deductible is,
impact on the value of the firm.
We now reason that using ct (see Equation (1)) as a rt =:r(1 - t) = ( Xr=r(l-)=(
S )(Os
- t)
iD
(8)
discount or cutoff rate in the capital budgeting deci-
sion is inappropriate and that a higher rate, c* (see where S is the value of the firm's equity as observed in

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 F. D. ARDITTI AND H. LEVY/THE WEIGHTED AVERAGE COST OF CAPITAL 27

the market. If interest were not tax deductible, then particular project, then its annual after-tax expected
the appropriate expected rate of return on equity, rt, is cash flow is written as
defined by
Y - t(Y - Dp - i(D/V)I) = (1- t)Y + tDp +
S = (X(l -t)- iD)/rt (9) ti(D/V)I. (13)
or
Obviously, using the cash flow
(12) rather than Equation (13) i
t = (X(l - t)- iD)/S. (10)
the firm (or its project's cash flo
But adding and subtracting tiD in the numerator
burden thanon it actually does.
the right hand side of Equation (10) reveals
It isthat
obvious that in practice
each project by the same debt-eq
rt = (X - iD) (1 - t)/S - tiD/S = r(l -t)- tid/S
a particular project is entirely
rt - tiD/S. (11) market assumes that this distortion in the firm's
capital structure is only temporary, since subsequent
Thus we see that tax deductibility raises
projects the
will be expected
financed so that the firm's target debt-
post-tax rate of return on equity, because
equity ratio Equation
is met. Also, temporary changes in the
(11) says that rt or r(l - t) exceeds rt. Since the text-
market value of debt-equity ratio are ignored. We
books write the cost of equity assume
as we have,
that when thethen thisthere is a perma-
firm thinks
means that the tax benefit of interest
nent change deductibility is
in this mix it is corrected by issuing more
already accounted for in the textbook cost of equity.
debt or stocks.
Hence, reducing the cost of debtBeranek
by the tax
[2] has shield
shown that thetorequired rate of
obtain (1 - t)i yields an incorrect
return weighted average
is a function of the cash flow used in the proj-
cost of capital. ect's evaluation. He examines three possible
In Appendix A we show that Modigliani
definitions and
of cash flow, but he does not consider the
Miller's evaluation model [8] also cash
implies
flow suggested in thiscost
that the paper. He also deals with
of debt is i rather than (1 - t)i.
capital structure which varies over time, a case in
which the weighted average cost of capital is
Project Evaluation meaningless, since the weights change from period to
Suppose that the firm faces a proposal with initial period. Obviously, for each arbitrary definition of
outlay of I and pre-tax annual earnings of Y for n cash flow, one can always find a corresponding dis-
years. The textbook recommendation is to calculate count rate which guarantees that the project will be
the net present value as acceptable only if it is worthwhile from the stock-
holders' point of view. For example, one can define the
NPV (- t)(Y-Dp)+ Dp n cash flow which is distributed to the stockholders, and
NPV = ( - I = 1
j 1 (1 + ct)j j = use the cost of equity as a cutoff rate for investment
decision-making.
(1- t) + tDp We discuss in this paper two definitions of cash
(12)
(1 + Ct)J flow:
1) (1 - t)Y + tDp which is the classical textbook
where Dp is annual depreciation (zero salvage is as- definition of the cash flow, and
sumed), and ct is given by [rt(S/V) + (1 - t)i(D/V)], 2) As above, plus the interest tax shield ti(D/V)I.
and if NPV is greater than 0, accept the project, and if We claim that the second definition is the correct
not, reject. (Note that we continue to use ct as the dis- one since it is the true cash flow received by the firm.
count rate, which implies that we are assuming that Indeed, this definition is used by M&M when they ex-
new projects do not alter the firm's risk class.) amine the present value of the firm; that is, they also
We are aware that the firm may finance this project take the interest tax shield into account in the firm's
partly by debt, and that if the intent of the firm is to cash flow.
keep constant its debt-equity ratio, then the firm will For the correct definition of cash flow (definition 2),
raise (S/V)I of equity and (D/V)I of debt to finance the corresponding cost of capital is given by Equation
this project. This new debt will generate some added (6). One can correctly argue (see Beranek [2]) that
cash flows by virtue of the tax deductibility of the in- the textbook definition of cash flow (definition 1) can
terest. If we attribute this increase in cash flow to the be used, and a discount rate can be found which will be

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28
consistent with this definition. Indeed, textl
writers use definition 1) of cash flow and the defin
given by Equation (1) for the discount rate. We c
that these two deviations from the correct defini
of the project's cash flow and the appropriate disc
rate do not change the decision-making except in s
specific cases. In general, an error is invo
Therefore, although Beranek [2] is correct in his c
that some corresponding discount rates can be f,
for each definition of cash flow, we claim that the
responding discount rate recommended in most
books is in general incorrect.
In sum, the textbook approach seems to admil
mistakes: 1) the cost of capital is incorrectly speci
and 2) the project's cash flows are measured w
downward bias. These two mistakes operate in
posite directions and may cancel. However, a
shall shortly see, this is not generally true. A proj
net present value measured using the cash flov
Equation (13) and c*, hereafter denoted by NI
may differ from the textbook NPV calcula
Moreover, a project can be accepted by one me
and rejected by the other. Consequently, the textl
NPV method may lead to a non-optimal decisi4
The differences resulting from evaluating a pr
by NPV or NPV* are analyzed below for 1
different cases: 1) a perpetuity with zero NPV;
perpetuity with non-zero NPV; and 3) a finit
project with no constraint on its NPV.
Case 1: A Perpetuity With Zero NPV
Consider a marginal project whose contributi(
the net present value of the firm as measured by I
is zero, a project whose acceptance or rejection is
consequence to the firm. We show below that ir
case, NPV* = NPV, i.e., the two conceptual mist
discussed above exactly offset each other.
Since Dp = 0 for a perpetuity and, Y = Y foi
year j, we have
NPV= . (It) -I= (-t I
j (+ ct)J Ct
and
NPV* - (1- t)Y + ti(D/V)I _
j = 1 (1 + c*)J
(1 - t)Y + ti(D/V)I _
c*
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FINANCIAL MANAGEMENT/FALL 1977
From Equations (1) and (2) we know that
c* = ct + ti(D/V) (16)
and can therefore write Equation (15) as
NPV* - (1 - t)Y + ti(D/V)I _ I (17)
ct + ti(D/V)
Placing all terms on the right hand side of Equation
(17) over a common denominator, and simplifying,
gives
NPV* = (1 - t)Y - ctI (18)
ct + ti(D/V)
But by Equation (14) the assumption of NPV = 0
means
(1 - t)Y = ctI. (19)
Substituting this result in Equation (18), we find
that if NPV = 0 then NPV* = 0. Thus, the aforemen-
tioned two mistakes of the NPV method exactly
cancel: reducing the cash flow by ti(-D-)I and the
discount rate by ti (D -) exactly offset each other, and
the project's net present value remains unchanged.
Case 2: A Perpetuity With Non-Zero NPV
Most projects that firms face have non-zero net
present value. Dividing the numerator and the de-
nominator of the first term on the right hand side of
Equation (17) by ct, and adding and subtracting I in
the transformed numerator of this term yields
NPV* ((1- t)Y)/ct - I + I + t(i/ct)(D/V)I _ I
1 + t(i/ct)(D/V)
(20)
Using the NPV formula as stated in Equation (14) and
defining
a C t(i/ct)(D/V), (21)
(14) Equation (20) can be rewritten as
NPV* = NPV/(1 + a). (22)
Thus, in this case of perpetual projects with NPV > 0,
NPV exceeds NPV* because a > 0; on the other hand,
for projects with NPV < 0, NPV is less than NPV*.
These conclusions are depicted in Exhibit 1. While
(15) NPV and NPV* may, in this case, differ in
magnitude, if the firm relies solely on the NPV
F. D. ARDITTI AND H. LEVY/THE WEIGHTED AVERAGE COST OF CAPITAL 29

Exhibit 1. PV* = (PV +aI)/(l +a). (25)

Using Equation (23) rather than Equation (24) in

Net Present
Value ($ ) determining the firm's asking price will lead to a non-
optimal decision, since PV does not correctly
indicate the magnitude of the present value of earnings
generated by the subsidiary. For example, suppose PV
= $107, I = $106, and a = .1. If the price offered the
NPV
firm for its subsidiary is $9.5 * 106, employing the PV
value the firm will refuse the offer, while if the PV*
N PV*\ value of $9.18 * 106 is used the subsidiary will be sold.
Once again note that if PV = I, i.e., NPV = 0, we ob-
tain from Equation (25) that PV* = PV, and the two
0^< ~Discount methods provide the same asking price.
Rate

NPV* Case 3: Finite Economic Life-

Unrestricted NPV
NPV ^/
Most projects considered by the firm have finite
economic life, so the following analysis is the most im
portant. We demonstrate that employing NPV rathe
than NPV* in this case may not only lead to an in
correct selling price for an existing asset but may also
calculation rather than NPV* it will nevertheless
result in a wrong accept-reject decision.
arrive at the same accept-reject decision.
Remember that in employing NPV or NPV*, S/V
Although the accept-reject decision on a new proj-
and D/V are used as weights in calculating the
ect in the perpetuity case is identical using NPV or
weighted average cost of capital. We must necessarily
NPV*, there remain situations where the use of NPV
assume a constant capital structure in applying both
may lead to non-optimal decisions by the firm. One
decision criteria, or the current weights S/V and D/V
example is sufficient to demonstrate our point. Sup-
are meaningless. Now, suppose the firm considers a
pose the firm has a subsidiary that it considers selling.
project with positive net present value. If the project is
What is the minimum price the firm will ask for its
accepted, the firm's market equity value increases
subsidiary? Clearly the initial investment, I, in this
from S to S,. If the firm wishes to maintain its prior
subsidiary is irrelevant, since it reflects historical cost.
capital structure, it can either finance this new projec
The relevant information for this decision is the pres-
by more debt or distribute immediately the extra value
ent value of the subsidiary's expected cash flow
as extra dividends. Adoption of the latter policy
stream. Retaining the perpetuity example, the conven-
means that an extra dividend equal to the project's net
tional calculation yields a present value, PV, of
present value drops the firm's equity to S and capital
PV = (1 - t)Y/ct (23)
structure remains unchanged.'
We now turn to the analysis of NPV vs. NPV* in
while this paper's proposed method of
the calculation
finite case:
gives

PV* = ((1 -t)Y + ti(D/V)I)/c*. (24) n (- t)Y + tDp

NPV= jZ (+c -I
j (+ c)J
Note that although the initial investment I
.represents historical cost, it nevertheless appears in
the PV* formula because we have a tax shield of
'Linke and Kim [6] have shown that
ti(D/V)I - recall that the proportion of I that is debt
capital is admissible as a discount rate
financed equals (D/V). Using Equation (16) to sub- structure is held constant. Howeve
stitute for c* in Equation (24), dividing top and bot-maintenance of a constant capital stru
firm's dividend policy - pehaps a n
tom by ct, and recalling the definition of PV as statedassumption in the above suggested p
in Equation (23), we write Kim proof, is that dividend policy

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 1
30 FINANCIAL MANAGEMENT/FALL 1977

The denominator is positive, thus the sign of NPV* is

(- t) +Ct
tD1][1-(
+ Ct
1 )n]-I (26) determined by the numerator. Since
and
I(1 + a[l-( )n]) [ ( )]
n (I =
NPV* - t)Y
. +(27)
tDp + ti(D/V)I (27) 1 + ct 1+c ti D
J =1 c*
I (1 + a)[1-
In Appendix B we show that using Equations ] (26)
(1 + Ct)n
and (27) one can obtain the following relationship
between NPV* and NPV:

NPV + I(l+a[l -( )]) (n (1 + +tiD +

NPV*=[ l+a t
[ ( Ct)n (1 + ct + ti D)n
a[(l+ct)nc D n ]}
(1 + ct)"
-(1+ct i(D/V) (28) (1+ ct + ti -)
1- (1 +ctCt
and both square bracketed terms are positive, call
their sum B, then NPV* exceeds NPV. Thus, if NPV
Where n is finite,2 it is possible that NPV and NPV*
is greater than 0, then NPV* will exceed zero, so that
give contradictory accept-reject decisions. For exam-
if a project is accepted by NPV it will also be accepted
ple, if I 100, n= 5, D/V= .8, t = .5, i = ., ct= .2,
we obtain for NPV = -1, NPV* = + 1.86. by NPV*, but if -B < NPV < 0 then the NPV
calculation rejects while NPV* accepts.
In general, we can show that the set of accept
decisions defined by NPV > 0 is contained in the set
of accept decisions defined by NPV* > 0. The proofNumerical Comparison of NPV
follows. We place the right hand terms of Equation and NPV*
(28) over a common denominator:
Below we present several tables (Exhibits 2-7) for
NPV* = different values of i, ct, and D/V that indicate the
magnitude of the difference between NPV and NPV*.
NPV + I(1 +a[l - ( )]) Our numerical analysis demonstrates, as one would
expect, that the number of errors in accept-reject
decisions increases with the debt-equity ratio and the
(1 +a)(1- (1 + ))Ct
1+ Ct interest rate, and decreases with ct (these are the com-
ponents of a). For example, compare the number of
positive NPV's in the NPV = -3 column of Exhibit 5
[1 - (1 + t + ti(D/V) )] with the number in that column of Exhibit 7; as the
debt-equity ratio rises, the probability increases of re-
(1 + a)(l- -( I )") jecting a valuable investment. A comparison of the
I +- ct

Exhibit 2: NPV* as a function of NPV and n for

I(+ a) [1 -( )n] i= .04, ct= .15, and D/V = .3.
I + c)
\NPV
(I + a) (I -( )n) (29)
I + ct n. -4 -2 -1 0 + 1 +5 +10
1 -3.98 1.99 .99 .00 .99 4.97 9.95
2 -3.76 -1.78 .78 .21 1.20 5.17 10.13
3 -3.59 -1.61 .62 .37 1.36 5.32 10.27
4 -3.46 -1.49 .50 .49 1.48 5.43 10.37
5 -3.37 1.39 -.41 .58 1.56 5.51 10.44
2For n oo, (28) gives NPV* = NPV/(I + a) as expected, and for n 10 -3.21 -1.26 -.28 .70 1.68 5.59 10.47
15 -3.31 -1.37 -.40 .57 1.57 5.43 10.29
= 1 NPV* = NPV [ c ]
20 -3.46 -1.53 .56 .41 1.37 5.25 10.08
I++ ct
Ct 25 -3.60 -1.67 .70 .27 1.23 5.09 9.92

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 F. D. ARDITTI AND H. LEVY/THE WEIGHTED AVERAGE COST OF CAPITAL 31

Exhibit 3: NPV* as a function of NPV and n for Exhibit 5: NPV* as a function of NPV and n for
i = .04, ct = .15 and D/V = .5. i = .10, , ct = .15, and D/V = .7.
NPV \NPV
n -2 1 0 +1 +2 n -3 -2 -1 0 +1 +2 +3

1.98 -.9 9 .00 .99 1.99 1 -1.94

-2.91 -.97 .00 .97 1.94 2.91
2 1.63 -.6 4 .35 1.33 2.32 2 -.76
-1.71 .20 1.16 2.12 3.07 4.03
3 1.36 -.3 7 .61 1.59 2.58 3 -.81 .13 1.08 2.02 2.97 3.91 4.85
4 1.15 .1 7 .81 1.79 2.77 4 -.16 .77 1.71 2.64 3.57 4.51 5.44
5 1.00 -.0 3 .95 1.93 2.91 5 .30 1.22 2.14 3.06 3.99 4.91 5.83
10 -.79 .1 7 1.14 2.10 3.06 10 .79 1.67 2.55 3.43 4.31 5.19 6.07
15 -.98 -.0 3 .93 1.88 2.83 15 .08 .93 1.78 2.63 3.48 4.34 5.19
20 1.25 -.3 0 .65 1.60 2.54 20 -.76 .08 .91 1.75 2.58 3.41 4.25
25 1.47 -.5 3 .42 1.36 2.31 25 -1.40 -.58 .24 1.07 1.89 2.72 3.54

NPV = -1 columns oftionExhibits

of a project the interest tax5 and
savings that can be6
at- provid
evidence that as ct decreases,
tributed to that debt other
financed portion parameters
of the project's h
constant, then the frequency of
cost should be excluded fromreject-accept
the project's cash flow. err
increases. Similarly, the NPV
The reason for the first= -1 columns
recommendation is that since of E
hibits 3 and 4 exemplify interest
the direct
is tax relation
deductible then between
the effective post-tax
creasing the interest rate
cost and the isgreater
Qf debt component number
actually (1 - t)i rather than of
vestment decision errors. Finally,
i. The argument used to supportathe
sense
second of
magnitude of errors inrecommendation
using NPV rather
is that financing than
sources cannot be N
is obtained by comparing
allocated tothe NPV
a particular =therefore
investment; -2 columns
the in-
Exhibits 2 and 7. terest tax saving should be excluded from the project's
Exhibits 8 and 9 graphically portray some of the cash flow stream. These two recommendations are es-
above conclusions. Exhibit 8 shows that, for positivesentially contradictory, however, for setting the cost of
NPV values, NPV* is non-negative. On the other debt equal to (1 - t)i, and applying the ct discount rate
hand, with negative NPV values, Exhibit 9 shows that to all projects, one does in fact take the interest tax
NPV* attains both positive and negative values de-saving into account and implicitly allocate the firm's
pending on the project's maturity. total debt financing to each project. We have
demonstrated that this procedure is inappropriate in
that it may lead to an incorrect decision.
Concluding Remarks
We have found that the correct weighted average
Virtually all textbooks recommend that 1) thecost of capital is
weighted average cost of capital,
c* = rt(S/V) + i(D/V)
ct = rt(S/V) + (1 - t)i(D/V),
in which the correct cost of debt component equals i
should be used as a cutoff rate, and 2) in the evalua-and not (1 - t)i. Note that interest tax savings are not

Exhibit 4: NPV* as a function of NPV and n for Exhibit 6: NPV* as a function of NPV and n for
i = .10, ct = .15, and D/V = .5. i = .10, ct = .20, and D/V = .7.
\NPV \NPV
n\ -10 -5 -1 0 +1 +5 +10 n -10 -5 -1 0 +1 +5 +10
1 -9.79 -4.89 -.98 .00 .98 4.89 9.79 1 -9.72
-4.86 -.97 .00 .97 4.86 9.72
2 -8.85 -4.00 -.13 .84 1.81 5.69 10.53 2 -8.55
-3.75 .08 1.04 2.00 5.84 10.63
3 -8.12 -3.32 .52 1.48 2.44 6.28 11.08 3 -7.72
-2.99 .81 1.75 2.70 6.49 11.23
4 -7.56 -2.82 .99 1.94 2.89 6.70 11.45 4 -7.16
-2.48 1.27 2.21 3.15 6.90 11.58
5 -7.17 -2.46 1.32 2.26 3.21 6.98 11.70 5 -6.80 -2.17 1.55 2.47 3.40 7.11 11.75
10 -6.52 -1.96 1.69 2.60 3.51 7.16 11.71 10 -6.63 -2.17 1.40 2.29 3.18 6.75 11.21
15 -6.86 -2.41 1.15 2.04 2.93 6.49 10.94 15 -7.28 -2.92 .57 1.44 2.31 6.67 10.16
20 -7.38 -3.00 .51 1.38 2.26 5.77 10.15 20 -7.83-3.53 -.08 .78 1.64 5.94 9.39
25 -7.82 -3.48 -.01 .86 1.73 5.21 9.55 25 -8.17 -3.89 -.47 .39 1.24 5.52 8.94

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32 FINANCIAL MANAGEMENT/FALL 1977

Exhibit 7: NPV* as a function of NPV and n for Exhibit 9.

1 = .10, ct = .15, and D/V = .8.

NPW
NPV
n \ -4 -3 -2 -1 0 +1 +2 ($)
1 -3.87-2.90 -1.93 -.97 .00 .97 1.93
2 -2.40-1.54 -.59 .36 1.31 2.27 3.22
3 -1.47-.53 .41 1.35 2.28 3.22 4.16
4 -.72 .20 1.13 2.05 2.98 3.90 4.82
5 -.20 .71 1.62 2.53 3.44 4.36 5.27
10 .35 1.22 2.08 2.95 3.81 4.67 5.54 3
15 -.45 .39 1.22 2.06 2.89 3.72 4.56
20 -1.36 -.55 .27 1.08 1.90 2.71 3.53
25 -2.07 -1.26 -.46 .35 1.15 1.95 2.76

ignored in this formula, because we have proved that n(yea!rs)

such savings are accounted for in the post-tax equity
cost, rt, or (1 - t)r. Therefore, by taking the cost of
debt component to be (1 - t)i rather than i, one double
counts the benefit of interest tax deductibility -
resulting in a lower cutoff rate ct when compared to
the correct rate c*.
A second error in project evaluation can be at-
tributed to the textbook recommendation that interest
tax savings should be excluded from a project's cash
flows. These two mistakes operate in opposite direc-
tions and the "textbook NPV" project evaluation
method may lead to a correct decision - but often
will not. Specifically, we find that: 1) For a project
with a perpetual expected cash flow stream, NPV*
equals NPV/(I +a), where a > 0, and NPV* sym-
Exhibit 8.
NPV*
($)
100'
80
60
40-
NPV=-5
-5
bolizes the net present value calculation that does not
double count interest tax savings in the project's cash
flow stream. Clearly, using NPV or NPV* results in
the same accept-reject decision; however, the use of
NPV to set the minimum sale price of a subsidiary is
obviously non-optimal; and 2) For projects having
finite economic life, the textbook accept-reject rule
(NPV) is not generally correct in that projects with
negative NPV will often be characterized by positive
NPV* and should be accepted.
Everyone seems to agree that, in valuing a firm, in-
NPV=100 terest tax savings should be considered as part of the
firm's cash flow - as Modigliani and Miller have
done [8]. What is the difference between valuing a
firm that one may wish to buy and evaluating a proj-
ect? It seems reasonable that the same solution
procedure should be applied to both problems.
NPV 50

References

1. F. Arditti, "The Weighted Average Cost of Capi

20-
NPV=O Some Questions on its Definition, Interpretation,
I., NPV= 10 Use," Journal of Finance (September 1973), pp. 10
. \ NPV= 5 08.
I , . -- _ . ,NPV= I
) 10 20 30 40 50 2. W. Beranek, "The Cost of Capital, Capital Budgeting
n(years) and the Maximization of Shareholder Wealth," Journal

This content downloaded from 115.113.11.142 on Thu, 09 Nov 2017 09:09:04 UTC
All use subject to http://about.jstor.org/terms
F. D. ARDITTI AND H. LEVY/THE WEIGHTED AVERAGE COST OF CAPITAL 33

of Financial and Quantitative Analysis (March 1975), 8. F. Modigliani and M. Mi

pp. 1-20. and the Cost of Capital
3. C. W. Haley and L. D. Schall, The Theory of Financial Economic Review (June 1
Decisions, New York, McGraw-Hill Book Co., 1973. 9. F. Modigliani and M. M
4. R. W. Johnson, Financial Management, 4th edition, Corporation Finance and
Boston, Allyn and Bacon, Inc., 1971. American Economic Revi
5. H. Levy and F. Arditti, "Valuation Leverage and the 10. Stewart C. Myers, "Int
Cost of Capital in the Case of Depreciable Assets," ing and Investment De
Journal of Finance (June 1973), pp. 687-93. Capital Budgeting," Jour
6. C. Linke and M. Kim, "More on the Weighted Average pp. 1-25.
Cost of Capital: Comment and Analysis," Journal of 11. J. Van Home, Financial Management and Policy, 2nd
Financial and Quantitative Analysis (December 1974), edition, Englewood Cliffs, New Jersey, Prentice-Hall,
pp. 1069-80. Inc., 1971.
7. M. Miller and F. Modigliani, "Dividend Policy, Growth 12. F. Weston and E. Brigham, Managerial Finance, 5th
and the Valuation of Shares," Journal of Business (Oc- edition, Hinsdale, Illinois, Dryden Press, 1975.
tober 1961), pp. 411-33.

Appendix A and assuming that the firm finances all investments at

In this Appendix we demonstrate that the
Modigliani & Miller (M&M) framework also implies
that the cost of debt should be i. To see this, note that
M&M's post-tax cutoff rate, when the tax savings
amounting from debt financing are included, is (using
our notation),
the same capital structure, D/V, then
dXt/dI = pt[l - t(D/V)] + ti(D/V).
Adding and subtracting (1 -t)i(D/V) and writing pt as
pt((S+D)/S) (S/V) we obtain

dXt/dI = (1 - t)dX/dI + ti(dD/dI) dXt/dI = [pt + (1 -t)(pt - i)D/S](S/V) + i(D/V).

since
Noting that the bracketed term is M&M's post-tax
dX/dI = Pt -t(dD/d cost of equity, we see that in their framework the cost
dX/dI = (1- t) [1- t(dD/dI)]
of debt emerges as i.

Appendix B Using Equation (16) and summing gives

In this Appendix we derive Equation (28). The (1 -t)Y + tDp[l ( i )n]

definition of NPV and NPV* are given by (B-l) and
NPV*=[ ct 1 + ct
(B-2), respectively,
- [ct + ti(D/V)]
n (- t)Y + tDp
NPV= .2 ' - I = Ctti
j= I (c + ct)
tct
(D/V)I[1-(
1 ct]
1 )n]
[ (-t) ct
YP ][1-( 1 )n]-I (B-l)
1 ct
Ct
[ct + ti(D/V)]

and 1 )n
-(1 + ct + ti(D/V)
NPV* = j (1- t)Y + tDp + ti(
j= 1 c*, - (1 + (B-3)
1 ' ct (B-3)

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34 FINANCIAL MANAGEMENT/FALL 1977

or
where a = (ti/ct) (D/V).
Subtracting and adding I to the numerator of the first
(1- t)Y + tD
l+cI term on the right hand side of Equation (B-4), and
r ct I + ct )"]
NPV* I
L
1+ a
+ recalling the definition of NPV as stated in (B-l), we
finally obtain

aCI[1-( 1 )n] l+c

NPV + I(1 + a[l - ( )n])
I +T Ct
1li-a
+ C NPV* = [ 1+ a
1
I
J

1 - ( An
11 + ct + ti(D/V)
(B-4)
- I - (1 + ct + ti(D/V) )
1 I )n [I + C

I + ct 1-(1+ ct)

SOUTHWESTERN FINANCE ASSOCIA TION

(in conjunction with the Southwestern Federation of
Administrative Disciplines)
1978 ANNUAL MEETING
CALL FOR PAPERS

The Southwestern Finance Association will hold its annual meeting March
8-12, 1978, in conjunction with the Southwestern Federation of Ad-
ministrative Disciplines in Dallas, Texas. The headquarters hotel for the
meeting will be the Fairmont. Persons interested in presenting a paper
should submit the completed paper or a three page abstract to Dr. Don L.
Woodland, College of Business Administration, Louisiana State Univer-
sity, Baton Rouge, LA 70803. An expanded program is planned to include
all areas of financial management, public finance, real estate finance, in-
vestment analysis, portfolio management, capital budgeting, bank
management, financial markets, monetary policy, insurance, risk manage-
ment and public utility rate making.

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