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Are costs of capital necessarily constant over time and across states of nature?

Author

Listed:
  • Lorenz, Daniela
  • Kruschwitz, Lutz
  • Löffler, Andreas

Abstract

Miller (2009a) opened a debate in this journal on the correct determination of weighted average costs of capital (WACC). So far Bade (2009), Pierru (2009a), Lobe (2009) as well as Keef, Khaled, and Roush (2012) have contributed to this debate. Even though they discuss the same, rather simple valuation problem, the dispute cannot be considered resolved. Whilst they agree that Miller erroneously assumed constant leverage ratios, the center of discussion is now placed on the question whether or not cost of capital is constant over time when leverage changes and interest paid is not tax deductible. In particular, Keef et al. (2012) demand time-invariant WACC and criticize Bade (2009) and Pierru (2009a) for allowing WACC to change over time. The aim of this paper is twofold. Firstly, we show that the arguments of Keef et al. (2012) are flawed and their criticism of Bade (2009) and Pierru (2009a) is thus unfounded. Keef et al. (2012) are wrong to ignore that not only financial risk but also operational risk can change over time. Secondly, we provide evidence that cost of capital can also be dependent on the future state of nature. So far this fact has been neglected by all contributors to this debate and becomes obvious only if state-dependent cash flow realizations, not only their expected values, are considered as well.

Suggested Citation

  • Lorenz, Daniela & Kruschwitz, Lutz & Löffler, Andreas, 2016. "Are costs of capital necessarily constant over time and across states of nature?," The Quarterly Review of Economics and Finance, Elsevier, vol. 60(C), pages 81-85.
    • Handle: RePEc:eee:quaeco:v:60:y:2016:i:c:p:81-85
    DOI: 10.1016/j.qref.2015.08.003
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    Citations

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    Cited by:

    1. Lucie Rudolfová, 2018. "The dependence of the costs of borrowed interest-bearing capital on the chosen financial variables [Závislost nákladů úročeného cizího kapitálu na vybraných finančních ukazatelích]," Český finanční a účetní časopis, Prague University of Economics and Business, vol. 2018(4), pages 51-69.

    More about this item

    Keywords

    Valuation; Discounted cash flow; Cost of capital;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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