On the Correct Evaluation of Cost of Capital for Project Valuation

Applied Mathematical Sciences, Vol. 9, no. 132 , 2015, 6583-6604

22 Pages Posted: 19 Oct 2015 Last revised: 5 Mar 2017

See all articles by Carlos Heitor Campani

Carlos Heitor Campani

The COPPEAD Graduate School of Business - Federal University of Rio de Janeiro (UFRJ)

Date Written: October 19, 2015

Abstract

This paper fills a very important gap in the literature with a straightforward methodology that generalizes the classic Modigliani and Miller results and provides correct values for the expected return on equity and for the weighted average cost of capital (WACC). After some confusing debate in the literature, we show that these correct values make the three main project valuation approaches (WACC, flow to equity and adjusted present value) to perfectly match. Specifically, we show that the expected return on equity for finite horizon projects will be horizon dependent, which means that it will (sometimes drastically) change as the project life shortens even when all other variables remain constant (e.g., the leverage ratio). Obviously, this result will directly affect the WACC. Another interesting result is that the traditional textbook formula for the WACC is not always correct, even for perpetual projects.

Keywords: Cost of Capital. Project Valuation. WACC

JEL Classification: G11, G31

Suggested Citation

Campani, Carlos Heitor, On the Correct Evaluation of Cost of Capital for Project Valuation (October 19, 2015). Applied Mathematical Sciences, Vol. 9, no. 132 , 2015, 6583-6604, Available at SSRN: https://ssrn.com/abstract=2676029

Carlos Heitor Campani (Contact Author)

The COPPEAD Graduate School of Business - Federal University of Rio de Janeiro (UFRJ) ( email )

Rua Pascoal Lemme n. 355
Rio de Janeiro, 21949-961
Brazil

HOME PAGE: http://www.coppead.ufrj.br

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