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Miles-Ezzell's WACC Approach Yields Arbitrage

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  • Löffler, Andreas

Abstract

A simple counterexample shows the the widely used WACC approach to value leverage firms developed by Miles and Ezzell can create an arbitrage opportunity. The only consequence to be drawn is that their WACC approach cannot be applied under the circumstances assumed by Miles and Ezzell. We show how the WACC has to be modified in order to obtain proper results. We develop a theory in continuous as well as discrete time. In discrete time it turns out that with a further assumption on the cash flows of the firm formulas similar to Miles and Ezzell's results can be verified. This assumption requires that the increments of cash flows have to be uncorrelated. This is a much weaker assumption than independent increments which is used in models of random walk.

Suggested Citation

  • Löffler, Andreas, 2002. "Miles-Ezzell's WACC Approach Yields Arbitrage," Hannover Economic Papers (HEP) dp-248, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    • Handle: RePEc:han:dpaper:dp-248
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    References listed on IDEAS

    as
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    3. Robert A. Taggart & Jr., 1991. "Consistent valuation and Cost of Capital Expressions With Corporate and Personal Taxes," Financial Management, Financial Management Association, vol. 20(3), Fall.
    4. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
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    Keywords

    WACC; leverage ratio; tax shield;
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