The Quarterly Review of Economics and Finance 49 (2009) 12131218

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The Quarterly Review of Economics and Finance

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Discussion

The weighted average cost of capital is not quite right: Reply to M. Pierru
Richard A. Miller
Economics Department, Wesleyan University, 238 High Street, Middletown, CT 06459, United States

a r t i c l e

i n f o

a b s t r a c t
In this journal [Miller, R. A. (2009). The weighted average cost of capital is not quite right. The Quarterly Review of Economics and Finance, 49, 128138], I argued that the standard WACC formula is inadequate in most circumstances to reward stockholders and bondholders where the necessary cash ows are calculated separately to exactly cover the respective costs of capital. Axel Pierru [2009. The weighted average cost of capital is not quite right: A comment. The Quarterly Review of Economics and Finance, 49, 12191223] observes correctly that my assumed repayment schedules (equal periodic payments to bondholders; similarly for stockholders) imply a temporal drift in the debt (or leverage) ratio; he would recalculate the WACC annually. He proposes an alternative calculation of the repayment schedules under the constraint of a constant debt ratio. Here I suggest three additional possible repayment schedules; in general repayment schedules determine the drift in the debt ratio. However, the expected repayment schedules are established at the time the project is accepted and nanced, hence the relevant debt ratio is that which exists at that time. The WACC for a specic project need not (and should not) be recalculated for that project throughout its nancial life when that project has already been accepted and nanced. 2009 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.

Article history: Received 11 November 2008 Accepted 21 November 2008 Available online 7 December 2008 JEL classication: G11 G3 Keywords: WACC Cost of capital Debt ratio Leverage Repayment schedules

In my prior paper on the WACC (Miller, 2007) I argued that for most situations the standard formula for the WACC produces inadequate cash ows to stockholders and bond holders when those CFs are

Tel.: +1 860 6852354; fax: +1 860 6852301. E-mail address: ramiller@wesleyan.edu.

1062-9769/$ see front matter 2009 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.

doi:10.1016/j.qref.2008.11.002

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calculated separately.1 My argument rests on these two assumptions: (a) the debt repayment schedule (a self amortizing bond like a house mortgage) involves equal periodic payments to the bond holders and (b) the equity repayment schedule is treated in an identical fashion, that is, the two repayment schedules or ows (different from each other) involve equal payments over time. The problem with the standard WACC formula comes from the linear combination (the weighted average) of the cost of equity capital and the cost of debt capital, when the combination (to get a single combined cost of capital) is in fact non-linear. Axel Pierru notes (correctly) (Pierru, 2008) that as time passes during the life of the acquired asset the nancial leverage (the debt ratio) changes. I am indebted to him for pointing this out. His Table 2 reports the standard WACC recalculated2 for each year over the life of the asset to reect the changing debt ratio, which also is the life of the debt and the life of the equity, since both sources of funds are (by these assumptions) self amortizing. His calculations show the WACC rising from 0.1050 at the end of year 1 to 0.1068 at the end of year 8 (the assumed life). (The costs of equity (0.12) and of debt (0.06) are assumed to be unchanged.) The debt ratio, not reported in Table 2, can be easily calculated from columns (3) and (4) as [amount of outstanding debt/(amount of outstanding debt and equity value)], and it falls from 0.25 at the start to 0.21982 at T = 8. M. Pierru suggests an alternative, a second pair of repayment schedules (his Table 1) for debt and equity based on the constraint that the debt ratio remains 0.25 through the life of the asset (and also the lives of both sources of nancing). Under this constraint the payments to debt holders rise each year3 , and the payments to equity holders (Equity residual cash ows) fall, over the 8 years; the sum each year is $38,173.9, calculated as the necessary cash ow (normal prot) based on the standard WACC, here 10.5%. This procedure substitutes one constraint (the constant debt ratio) for another (constant repayment schedules). M. Pierru argues that [Millers] Eq. (2) is not consistent with [his] Eqs. (8) and (9). . .4 My Eq. (2) calculates the necessary CF for the WACC of 10.5% (the equity and debt CFs not separated), while my Eqs. (8) and (9) calculate the necessary CFs for debt and equity considered separately at their respective costs of debt and equity nancing. The inconsistency thus involves a drift in the nancial leverage (the debt ratio), which, M. Pierru argues, implies a corresponding drift in the WACC. What is important, however, is the set of nancial conditions existing at T = 0, when the project is accepted (the asset acquired) and its nancing undertaken (for a specic debt ratio, cost of equity, cost of debt, and life of the project). If the debt ratio is expected to change as time passes, then those expectations are built into rd and re at T = 0. M. Pierru develops his argument (as I did) based on self amortizing debt and self amortizing equity, i.e. the entire CF is paid out as the asset ages and as the values of debt and of equity decline to zero at maturity (T = 8). What if the repayment schedules are not of the self amortizing type, i.e. some of the CF is retained, earning the necessary costs of capital for debt and for equity? With such retention, the drift over time in the projects debt ratio should be interpreted as the projects contribution to the rms overall debt ratio. The following three pairs of alternative repayment schedules should be interpreted in this manner. My paper (Section 3) suggests a third pair of repayment schedules: (a) to bond holders pay the interest annually (6% of $50,000, or $3000 per year), retaining the residual ($8051.80 as calculated from my Eq. (9) less $3000, or $5051.80 per year) and investing that residual at the cost of debt capital (6%) which will accumulate, over the 8 year life of the debt, an amount exactly sufcient to repay the principal of $50,000 (my Eq. (11)); and (b) to stockholders pay the dividend annually (12% of $150,000, or $18,000 per year) retaining the residual ($30,195.43 as calculated from my Eq. (8) less $18,000, or $12, 195.43 per year) and investing that residual at the cost of equity capital (12%) which will accumulate over the 8 year life of the equity an amount exactly sufcient to repay the principal (original equity investment) of $150,000 (my Eq. (12)). These two repayment schedules are detailed in my Tables A.1 (for debt) and A.2 (for equity). The value of the debt each year remains $50,000; the

These cash ows are in the nature of normal prot an opportunity cost for equity and debt. The arguments and calculations in M. Pierrus paper and in this reply are based on zero corporate tax. See footnote 7; also Section 4 of Miller (2007), where I indicate that taxes are better accounted for in the pro forma income statement rather than in the WACC formula. 3 In practice most (perhaps all) of the bond repayment schedules are not of this sort. 4 Yes, Eq. (2) is not consistent with Eqs. (8) and (9): this is one way of describing a major point of my paper.
2

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Table A.1 Debt values for T = 0, . . ., 8: $3,000 per year paid as interest, the remaining $5,051.80 retained and growing at 6% per year, present value of outstanding debt, and total value of debt. (1) T 0 1 2 3 4 5 6 7 8 (2) Debt CF retained and growing (at rd = .06) $5051.80 $10,406.71 $16,082.91 $22,099.69 $28,477.47 $35,237.91 $42,403.99 $50,000.03 (3) Amount of outstanding debt (same as col. 3, Table 2) (4) Value of debt(2) + (3) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000

$50,000 $44,948.22 $39,593.31 $33,917.11 $27,900.34 $21,522.58 $14,762.11 $7,596.04 0

Calculations: Col. (2): the amount of CF for debt retained after paying the annual interest of 6% of $50,000, i.e.(8051.80 3000 = 55051.80), annually, accumulated each year (invested at the 6% cost of debt capital). For example, for T = 2: $5051.80 (1.06) + 5051.80 = 10,406.71; for T = 3: 10,406.71 (1.06) + 5,051.80 = 16,082.91; etc. Col (3): present value of the remaining annual CF to debt holders, discounted at 6%.
7 6 8051.80 (1.06)T T =1

For example, for T = 1:

= 44, 948.22, for T = 2:

T =1

8051.80 (1.06)T

= 39, 593.31; etc.

Table A.2 Equity values for T = 0, . . ., 8: $18,000 per year paid as dividends, the remaining $12,195.43 per year retained and growing at 12% per year, present value of remaining equity, and total value of equity. (1) T 0 1 2 3 4 5 6 7 8 (2) Equity CF retained and growing (re = .12) $12,195.43 $25,854.31 $41,152.26 $58,285.96 $77,475.71 $98,968.22 $123.039.84 $150,000.05 (3) Equity value of remaining equity CF $150,000 $137,804.59 $124,145.71 $108,847.77 $91,714.07 $72,524.33 $51, 031.82 $26,960.21 0 (4) Value of equity (2) + (3) $150,000 $150,000 $150,000 $150,000 $150,000 $150,000 $150,000 $150,000 $150,000

Calculations: Col. (2) the amount CF for equity after paying the annual dividend of 12% of $150,000 (=$18,000), i.e. (30,195.43 18,000 = 12,195.43) annually, accumulated each year (invested at the 12% cost of equity capital). For example, for T = 2: 12,195.43 (1.12) + 12,195.43 = 25,854.31: for T = 3: 25,854.31 (1.12) + 12,195.43 = 41,152.26, etc. Col. (3) present value of the remaining CF to equity suppliers, discounted at 12%.
7 6 30,195.43 (1.12)T T =1

For example, for T = 1:

= 137, 804.59, for T = 2:

T =1

30,195.43 (1.12)T

= 124, 145.71, etc.

value of the equity each year remains $150,000. This is the sense in which the bond holders and the equity holders are made whole at T = 8 when the asset no longer provides any CF and thus is worthless. Since with these repayment schedules the values of debt and equity remain unchanged (at $50,000 and $150,000 respectively) over the life of the project, the debt ratio also remains constant at 0.25.5 The annually recalculated WACC would remain constant, too; but these numbers and this argument are based on the calculation of the necessary cash ows for debt and equity considered separatelymy Eq. (8), (9), (11), (12), not on the overall CF implied by the standard WACC.

5 This pair of repayment schedules shares with M. Pierrus a constant debt ratio, but this third pair is not self amortizing; some of the cash ow is retained.

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Table A.3 Equity values for T = 0, . . ., 8: $5000 per year paid as dividends, the remaining $25,195.43 per year retained and growing at 12% per year, present value of remaining equity, total value of remaining equity, and debt ratio. (1) T 0 1 2 3 4 5 6 7 8 (2) Equity CF retained and growing (at re = .12) $25,195.43 $53,414.31 $85,019.46 $120,417.22 $160,062.72 $204,465.68 $254,196.99 $309,896.06 (3) Equity value of remaining equity CF $150,000 $137,804.59 $124,145.71 $108,847.77 $91,714.07 $72,524.33 $51,031.82 $26,960.21 0 (4) Value of equity (2) + (3) $150,000 $163,000.02 $177,560.02 $193,867.23 $212,131.29 $232,587.05 $255,497.50 $281,157.20 $309,896.06 (5) Debt ratio (D = $50,000 all years) 0.2500 0.2347 0.2197 0.2050 0.1907 0.1769 0.1637 0.1510 0.1389

Calculations: Col (2): the amount of CF for equity after paying the annual dividend of $5000, i.e. (30,195.43 5000 = 25,195.43) annually, accumulated each year (invested at the 12% cost of equity capital). For example, for T = 2: 25,195.43 (1.12) + 25, 195.43 = 53,414.31; for T = 3: 53,414.31 (1.12) + 25,195.43 = 85,019.46, etc. Col (3): present value of the remaining CF to equity suppliers, discounted at 12%, same as Col (3), Table A.2.

Bond holders are usually paid a periodic interest with the full principal repaid at maturity. Further debt nancing at T = 8 can be obtained by rolling over the debt with a new issue. This common procedure is represented by Table A.1. In contrast stock holders may be paid a dividend, but usually not one which greatly exceeds6 the accounting prot in the accounting income statements of Tables 1 and 2 of my paper. This suggests a fourth pair of repayment schedules. (a) Bond holders are paid annual interest ($3000) and the principal ($50,000) at maturity, T = 8 (Table A.1). (b) Stockholders are paid an annual dividend which is a portion of accounting prot. If the dividend is (approximately) 50% of the annual accounting prot ($10,247.23 in my Table 2) say $5,000 per year then a greater proportion of the CF for stockholders is retained: $30,195.43 $5,000 = $25,195.43 per year. These two repayment schedules are reasonable approximations of nancial practice. The implications are detailed in Table A.3. The annual retained equity CF ($25,193.43) growing at 12% per year grows to $309,896.06 (Col (4)) at T = 8. The debt value (Table A.1, Col (4)) is $50,000 at T = 8. The debt ratio, then, has fallen to ($50, 000/$50, 000 + $309, 896.06) = 0.1389. The possibility that the debt may be a payment-in-kind security suggests a fth pair of payment schedules. PIK bonds offer increasing debt rather than periodic monetary interest as the reward for lending; zero coupon bonds are the ultimate PIK security. To raise $50,000 in a zero coupon offering at 6% for eight years, the borrower must promise to repay $50,000 (1.06)8 = $79,692.40 at T = 8.7 If shareholders are paid $5000 in annual dividends, with the rest of the cash ow retained and earning 12% per year (as in the fourth pair of repayment schedules above, in Table A.3), then the values of debt and equity, and the resulting debt ratio (which falls to 0.2046), are displayed in Table A.4. The reinvestment calculations assume that the rm has investment opportunities that will provide 6% to bond holders and 12% to stockholders. If not, the cash ows should be returned to the suppliers of nance who, after all, have alternative opportunities earning 6% (bond holders) and 12% (stockholders). If these CFs are retained (because the 6% and 12% as opportunity costs of these sources of nancial capital can be met), then the fourth pair of repayment schedules (the closest to common business practice) of Table A.3 suggests the following: (a) the debt ratio falls unless additional nancial decisions are made;

6 By a factor of 1.5 to almost 2 as the dividend of $18,000 in Table A.2 suggests. However, the investors in some nancial rms hedge funds and venture capital funds are notable examples may expect their rms to be wound down, so this sort of payout is not unknown. 7 If the holder of the bonds (the lender) has the annual option of receiving more debt (PIK) or cash (interest), or a combination, his choice will depend on interest rates in nancial markets at the times the decisions must be exercised. These multiplier bonds or bunny bonds would make the annual calculations of the value of the debt impossible.

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Table A.4 Debt values on a zero coupon issue, T = 0, . . ., 8, growing at rd = .06; equity values for T = 0, . . ., 8: $5000 per year paid as dividends, the remaining $25,195.43 per year retained and growing at re = .12; debt ratio, T = 0, . . ., 8. (1) T 0 1 2 3 4 5 6 7 8 (2) $50,000 (1.06)T (value of debt) $50,000 $53,000 $56,180 $59,550.80 $63,123.85 $66,911.28 $70,925.96 $75,181.51 $79,692.40 (3) Value of equity (from Table A.3, Col. 4) $150,000 $163,000 $177,560.02 $193,867.23 $212,131.29 $232,587.05 $255,497.50 $281,157.20 $309,896.06 (4) Debt ratio 0.25 0.2454 0.2404 0.2350 0.2293 0.2234 0.2173 0.2110 0.2046

(b) to retain the same desired leverage the C.F.O. may rebalance the nancing, perhaps by issuing additional debt, as time passes; (c) if the cash ow (for stockholders) cannot be utilized in other investment opportunities, the C.F.O. may propose a special dividend and/or repurchase of some outstanding shares, which will slow the fall in the debt ratio. In general, these ve pairs of repayment schedules suggest that the debt ratio (for a project, calculated over the life of the project) is sensitive to which repayment schedule is used in practice. M. Pierru is correct to note that the repayment schedules and the debt ratio are related; he would further conclude that the WACC recalculated through time is dependent on the changing debt ratio which depends in turn on which repayment schedules are being employed. However, what is relevant for a decision made at T = 0 are the costs of debt and equity (rd , re ) which exist at that time. My modied WACC formula (my Eq. (23)) is determined by (arbitrarily) assuming constant debt and equity cash ows. . . (Pierru, 2008, 5) Each of the ve pairs of repayment schedules (my original set, his alternative, and the three additional pairs discussed here) is arbitrary; and the selection from among these and many other possible repayment schedules is a matter of judgment at the time the project is accepted and nanced. . . .[I]n any year, a projects debt ratio must be dened with respect to the value [i.e. the remaining value] of the project. (Pierru 2008, 1) True: the projects debt ratio may change as time passes, but the original debt ratio (0.25 in these examples) and the repayment schedules for debt and equity determined at T = 0 are relevant to the capital budgeting decision. The market values of the debt and equity after T = 0 do affect the recalculation of the debt ratio (of the project) as time passes, but the rms nancing decision has already been made. The WACC for a specic project need not (and should not) be recalculated for that project throughout its nancial life when that project has already been accepted and nanced. The 4th schedules reect corporate practice better than the others. Tables A.1 and A.2 demonstrate that the cash ows calculated by my Eqs. (8) and (9) are necessary to reward bond holders and stockholders with the necessary 6% and 12% annual return respectively, as my paper argues. Moreover, under the third pair of repayment schedules the retention and reinvestment of the amounts beyond $3000 per year (bond holders) and $18,000 (stockholders), earning 6% and 12% respectively, produce amounts which will (at T = 8) exactly make the bond holders whole ($50,000) and also the stockholders ($150,000), while maintaining a constant debt ratio of 0.25. Considering the necessary cash ow to exactly justify an investment (i.e. earning the normal prot) without considering the separate necessary cash ows for debt and equity will (usually) result in error, although that error is very likely to be small. The WACC as commonly calculated is (generally) too low not quite right and it produces (generally) an insufcient cash ow to reward both stockholders and bond holders with their respective costs of capital.8

8 Taxation of corporate accounting prot still produces a cash (out) ow which is a cost properly considered in income statement analysis. Including (1-tax rate) in the WACC formula still seems misplaced; stockholders still require re and the bond

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Acknowledgement The author gratefully acknowledges the assistance and comments of Madeleine Howenstine and Iwan Djanali. References
Miller, R. A. (2009). The weighted average cost of capital is not quite right. The Quarterly Review of Economics and Finance, 49, 128138. Pierru, A. (2009). The weighted average cost of capital is not quite right: A comment. The Quarterly Review of Economics and Finance, 49, 12191223.

holders still require rd [and the associated cash ows] regardless of the tax deductibility of interest payments. Table 2 of my article still applies.