Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

P1: TIX/XYZ P2: ABC

JWBT436-c09 JWBT436-Baker February 11, 2011 8:57 Printer Name: Hamilton

CAPITAL STRUCTURE IRRELEVANCE:THE MODIGLIANI-MILLER MODEL 161

where:

␺ =the cost of tax savings; and VTS = the value of tax shield. This formula can

be rearranged to a more intuitive form of the weighted average of specific

discount rates:

K

e

= K

u

VUE

VLE

−d

VD

VLE

+␺

VTS

VLE

(9.4)

where VUE = the value of unlevered equity. Equation 9.4 allows formulating a

generalization of Proposition II. That is, the cost-of-equity formula is nothing more

than a weighted average of specific discount rates, where the weights are the values

of unlevered equity, debt, tax shield, and other components of capital structure, all

divided by the value of levered equity. This rule may be generalized even further

for any cost of capital including WACC. The only special feature of traditional

WACC is that it is designed to value a firm on the basis of unlevered cash flow

without tax savings and the effect of tax savings is added through the WACC.

According to V

´

elez-Pareja and Burbano-P

´

erez, the generalized WACC formula is

(Equation 9.5):

WACC = K

e

VLE

VLF

+d

VD

VLF

+␺

VTS

VLF

−

TS

VLF

(9.5)

where:

TS =the periodic tax savings; and VLF = the value of a levered firm.

Myers (1974), researching interactions between corporate financing and in-

vestment decisions, derives a general adjusted present value (APV) rule for capital

budgeting decisions. He assumes that