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Because leverage increases the riskiness of the cash flows to equity investors, leverage increases the
cost of equity capital. But for moderate amounts of leverage, the impact of the tax shield on the cost of
debt financing overwhelms the rising cost of equity financing, and leverage reduces the WACC.
Economists Franco Modigliani and Merton Miller were each awarded the Nobel Prize in economics
(in 1985 and 1990, respectively) for work that included research on this very issue. Modigliani and
Miller proved that in a world where there are no taxes and no bankruptcy costs the WACC is
unaffected by leverage. What about the real world, in which taxes and bankruptcy exist? What we
learn from their result, known as the Modigliani-Miller irrelevance theorem, is that as leverage is
increased WACC falls because of the tax savings, but eventually WACC starts to rise again due to the
rising probability of bankruptcy costs. The choice of debt versus equity financing must balance these
countervailing concerns, and the optimal mix of debt and equity depends on the specific details of the
proposed project.
Divisional versus Firm Cost of Capital
Suppose the beer company is thinking about opening a restaurant. The risk inherent in the restaurant
business is much greater than the risk of the beer brewing business. Suppose the WACC for the
brewery has historically been 20%, but the WACC for stand-alone restaurants is 30%. What discount
rate should be used for the proposed restaurant project?
Considerable research, both theoretical and empirical, has been applied to this question, and the
consensus is that the 30% restaurant WACC should be used. A discount rate must be appropriate for
the risk and characteristics of the project, not the risk and characteristics of the parent company. The
reason for this surprising result is that the volatility of the project‟s cash flows and their correlation
with other risky cash flows are the paramount risk factors in determining cost of capital, not simply
the likelihood of default on the company‟s obligations. The financial analyst should estimate the
project‟s cost of capital as if it were a new restaurant company, not an extension of the beer company.
The analyst should examine other restaurant companies to determine the appropriate β, cost of equity
capital, cost of debt financing, financing mix, and WACC.
Other Decision Rules
Some firms do not use the NPV decision rule as the criterion for deciding whether a project should be
accepted or rejected. At least three alternative decision rules are commonly used. As we shall see,
however, the alternative rules are flawed. If the objective of the firm is to maximize investors‟ wealth,
the alternative rules sometimes fail to identify projects that further this end and in fact sometimes lead
to acceptance of projects that destroy wealth. We examine the payback period rule, the discounted
payback rule, and the internal rate of return rule.
The Payback Period