John R. Ezzell

The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification

For financial management to make wealth maximizing capital budgeting decisions, a model that will determine correctly the market value of a projects levered cash flows is required. A capital budgeting model should account not only for the effects of the investment decision, but also for the effects of the financing decision and the interactions between the two decisions. In perfect capital markets all the effects of the financing decision pertain to the tax shield created by debt financing. Thus, as originally shown by Modigliani and Miller [8], the value of a projects levered cash flow stream equals the market value the stream would have if it were unlevered plus the market value of the stream of tax savings on interest payments associated with the debt employed to finance the project. While this result is completely general with respect to the specific processes utilized by the market to value the two components, MM specified the value of the unlevered component as the present value of the unlevered cash flows discounted at the appropriate risk adjusted unlevered cost of capital and they specified the value of the tax savings component as the present value of the tax shield on interest discounted at the cost of debt. Accordingly, the value of a projects levered cash flows is specified as the sum of these two present values, one representing the effects of the investment decision and the other capturing the effects of the financing decision. The MM valuation model has been extended to normative capital budgeting analysis by Myers [9] in terms of the adjusted present value (APV) model.

Bank CEO Pay-Performance Relations and the Effects of Deregulation

The authors test the deregulation hypothesis that posits that bank CEO compensation became more sensitive to performance as bank management became less regulated. They observe a significant increase in pay-performance sensitivities from their 1976-81 regulation subsample to their 1982-88 deregulation subsample. These increases in pay sensitivities after deregulation are observed for salary and bonus, stock options, and common stock holdings. The authors observe increases in the pay-performance relation associated with high-capitalization-ratio banks, consistent with providing incentives for wealth creation while even larger increases in pay-performance sensitivity for lower capitalization-ratio banks suggest an Federal Deposit Insurance Corporation moral hazard problem. Copyright 1995 by University of Chicago Press.

Leasing versus purchasing: Direct evidence on a corporation's motivations for leasing and consequences of leasing

This paper provides new evidence on the possible sources of lessee equity value changes when leasing contracts are announced. We show that lessee common equity value increases significantly in sale and leasebacks and insignificantly in direct leases. We find support, in sale and leasebacks, for the tax-savings hypothesis and for the savings in bankruptcy costs hypothesis. We also find support for the hypothesis that leasing reduces the external financing costs related to adverse selection that arise in markets with asymmetric information. Finally, we show that lessees gain less in direct leases when they lease assets with salvage values that are sensitive to use.

FLOTATION COSTS AND THE WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (Ko) is presented in virtually all textbooks in financial management and capital budgeting as a practical concept fundamental to the actual selection of optimal financial and investment alternatives. As often employed Ko can be defined aswhereKo = the weighted average cost of capital,Ks = the cost of equity capital,Kb = the cost of debt capital,S = the market value of the firms equity,B = the market value of the firms debt, andV = S + B, the total market value of the firm.

Analyzing leases with the after-tax cost of debt

Abstract A generalized expression of the net advantage of leasing (NAL) is used to assess the implications of discounting incremental cash flows at the firms before-tax cost of debt and the firms after-tax cost of debt, respectively. If no personal tax biases are assumed, then the before-tax cost of debt should be used to compute NAL. If the before-tax cost of debt is the correct discount rate, then any change in the firms borrowing level brought about by the decision to lease rather than purchase will alter the computed NAL by the amount of the present value of the tax savings on interest payments. Thus using the before-tax cost of debt is consistent with basic MM valuation theory. Using the after-tax cost of debt, in contrast, implies that any associated change in the firms borrowing level is irrelevant for purposes of computing NAL. Sufficient conditions are specified for the after-tax cost of the debt to be the correct discount rate for lease versus purchase analysis. Finally, lease analysis in a MM world is compared to lease analysis in a Miller tax world. For the special case of a 100% leverage ratio, the specification of NAL is the same in both worlds. Use of the after-tax cost of debt is correct in a Miller world and is a good approximation in an MM world provided the cash flows are predominantly debt financed.

Effects of personal taxes and equity issuing costs on the firm's investment decision

Abstract The existence of preferential taxes on capital gains relative to ordinary income is widely understood to create a systematic preference for internal rather than external equity financing. This preference is magnified by the existence of issuing costs on new equity. This paper develops a procedure to account for these market imperfections in terms of an adjusted net present value that directly adjusts a projects net present value calculated without regard to the imperfections. Once the correct adjustment procedure is developed, the practical implications of personal taxes and issuing costs on the firms investment behavior clearly emerges. These market imperfections have created a discontinuous function for the firm in obtaining equity capital. Many rational wealth-maximizing firms are forced to make investment decisions in a situation similar to capital rationing as the separation theorem between investing and financing does not generally hold. This explanation of a potentially long-run need for capital rationing is consistent with otherwise perfect capital markets.