Planning Capital Expenditure 307and most important lesson to be learned about leverage from this example: For
the equity investors, leverage makes the good times better and the bad times
worse. One student of mine, upon hearing this, exclaimed, “Leverage is a lot
like beer!”
Because leverage increases the riskiness of the cash f lows to equity in-
vestors, 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 over-
whelms 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 in-
cluded 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 theo-
rem, 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 bank-
ruptcy 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 in-
herent 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 f lows and
their correlation with other risky cash f lows are the paramount risk factors in
determining cost of capital, not simply the likelihood of default on the com-
pany’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 de-
cision rules are commonly used. As we shall see, however, the alternative rules