492 Part Five Payout Policy and Capital Structure
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additional value. We were really assuming a Modigliani–Miller (MM) world in which all
financing decisions are irrelevant. In a strict MM world, firms can analyze real investments
as if they are all-equity-financed; the actual financing plan is a mere detail to be worked
out later.
Under MM assumptions, decisions to spend money can be separated from decisions to
raise money. Now we reconsider the capital budgeting decision when investment and financ-
ing decisions interact and cannot be wholly separated.
One reason that financing and investment decisions interact is taxes. Interest is a tax-
deductible expense. Think back to Chapters 9 and 17 where we introduced the after-tax
weighted-average cost of capital:WACC = rD(1 − Tc) D__
V
+ rE __E
V
Here D and E are the market values of the firm’s debt and equity, V = D + E is the total
market value of the firm, rD and rE are the costs of debt and equity, and Tc is the marginal
corporate tax rate.
Notice that the WACC formula uses the after-tax cost of debt rD (1 – Tc). That is how the
after-tax WACC captures the value of interest tax shields. Notice too that all the variables in
the WACC formula refer to the firm as a whole. As a result, the formula gives the right dis-
count rate only for projects that are just like the firm undertaking them. The formula works for
the “average” project. It is incorrect for projects that are safer or riskier than the average of the
firm’s existing assets. It is incorrect for projects whose acceptance would lead to an increase
or decrease in the firm’s target debt ratio.
The WACC is based on the firm’s current characteristics, but managers use it to discount
future cash flows. That’s fine as long as the firm’s business risk and debt ratio are expected to
remain constant, but when the business risk and debt ratio are expected to change, discounting
cash flows by the WACC is only approximately correct.
Many firms set a single, companywide WACC and keep it constant unless there are major
changes in risk and interest rates. The WACC is a common reference point that avoids divi-
sional squabbles about discount rates.^1 But all financial managers need to know how to adjust
WACC when business risks and financing assumptions change. We show how to make these
adjustments later in this chapter.Sangria Corporation (Market Values, $ millions)Asset value $1,250 $ 500 Debt
750 Equity
$1,250 $ 1,250Sangria Corporation (Book Values, $ millions)Asset value $1,000 $ 500 Debt
500 Equity
$1,000 $ 1,000(^1) See Section 9-1 under “Perfect Pitch and the Cost of Capital.”
Sangria is a U.S.-based company whose products aim to promote happy, low-stress lifestyles.
Let’s calculate Sangria’s WACC. Its book and market-value balance sheets are
EXAMPLE 19.1 ● Calculating Sangria’s WACC