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Weighted average cost of capital in the theory of Modigliani-Miller, modified for a finite lifetime company

Author

Listed:
  • Peter Brusov
  • Tatiana Filatova
  • Natali Orehova
  • Nastia Brusova

Abstract

The theory of the capital cost and the capital structure by Modigliani and Miller (MM) is based on many assumptions, removal of which significantly alters its conclusions. While the account of corporate and individual taxes, the possibility of bankruptcy and a number of other assumptions have received considerable attention, the MM assumption that all financial flows are perpetuity (the lifetime of the company is infinite) is much less studied. In fact, the lifetime of the company is always, of course, finite and the inclusion of this significantly changes formulae obtained by MM, in particular for the Weighted Average Cost of Capital (WACC). In this article, we consider the WACC of the company in the theory of MM and modify MM's theory for a finite lifetime company. For the first time, we derive the analytical expression for WACC of the company with arbitrary lifetime. In two limited cases - 1 year and perpetuity companies - our expression gives the well-known results of Myers and MM, correspondingly. We have solved the obtained equation for a 2 year company and compared this result with those of Myers and MM. It shows that WACC values for 2 year company is closer to MM (perpetuity) limit than to Myers (1 year) one at small equity cost (just above the debt cost) while at bigger equity cost, it is closer to Myers limit than to MM one. Algorithm for finding of WACC in the case of arbitrary lifetime of the project has been developed. The use of the obtained equations for the projects of n years, and for companies operating in the market n years significantly alters the assessment of the WACC of the company.

Suggested Citation

  • Peter Brusov & Tatiana Filatova & Natali Orehova & Nastia Brusova, 2011. "Weighted average cost of capital in the theory of Modigliani-Miller, modified for a finite lifetime company," Applied Financial Economics, Taylor & Francis Journals, vol. 21(11), pages 815-824.
    • Handle: RePEc:taf:apfiec:v:21:y:2011:i:11:p:815-824
    DOI: 10.1080/09603107.2010.537635
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    Citations

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    Cited by:

    1. Juhász, Péter, 2019. "A súlyozott átlagos tőkeköltség alkalmazásának kihívásai [Challenges in applying the weighted average cost of capital]," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 805-823.
    2. Peter Brusov & Tatiana Filatova & Mukhadin Eskindarov & Pavel Brusov & Natali Orehova & Anastasia Brusova, 2012. "Influence of debt financing on the effectiveness of the finite duration investment project," Applied Financial Economics, Taylor & Francis Journals, vol. 22(13), pages 1043-1052, July.
    3. Peter Brusov & Tatiana Filatova & Natali Orekhova, 2023. "Innovative Investment Models with Frequent Payments of Tax on Income and of Interest on Debt," Springer Books, in: The Brusov–Filatova–Orekhova Theory of Capital Structure, chapter 0, pages 501-528, Springer.
    4. Peter Brusov & Tatiana Filatova, 2021. "The Modigliani–Miller Theory with Arbitrary Frequency of Payment of Tax on Profit," Mathematics, MDPI, vol. 9(11), pages 1-25, May.
    5. Peter Brusov & Tatiana Filatova & Natali Orekhova, 2014. "Mechanism of formation of the company optimal capital structure, different from suggested by trade off theory," Cogent Economics & Finance, Taylor & Francis Journals, vol. 2(1), pages 1-13, December.
    6. P. Zhukov E. & П. Жуков Е., 2019. "Новые модели анализа изменений стоимости компании, основанные на стохастических ставках дисконтирования // New Models for Analyzing Changes in Company Value Based on Stochastic Discount Rates," Финансы: теория и практика/Finance: Theory and Practice // Finance: Theory and Practice, ФГОБУВО Финансовый университет при Правительстве Российской Федерации // Financial University under The Government of Russian Federation, vol. 23(3), pages 35-48.
    7. P. Zhukov E. & П. Жуков Е., 2018. "Разве стоимость компании действительно зависит от средневзвешенной стоимости капитала и свободного денежного потока? Свидетельства иррациональности в нефтегазовом секторе // Does Enterprise Value Real," Review of Business and Economics Studies // Review of Business and Economics Studies, Финансовый Университет // Financial University, vol. 6(1), pages 17-28.
    8. Justyna Franc-Dąbrowska & Magdalena Mądra-Sawicka & Anna Milewska, 2021. "Energy Sector Risk and Cost of Capital Assessment—Companies and Investors Perspective," Energies, MDPI, vol. 14(6), pages 1-20, March.
    9. Witte, Niklas, 2024. "Capital requirements in Pillar 1 or Pillar 2: does it matter for market discipline?," Working Paper Series 2988, European Central Bank.

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