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Most popular corporate finance literature (see for instance, Weston and Copeland,
1992; Brealey et al., 1995; Copeland et
al., 1995 and 2000; Damodaran, 1996; Benninga and
Sarig, 1997; Van Horne, 1998; Brealey and Myers, 2000 and 2003; Gallagher and Andrew,
2000; Benninga, 2006; and Brealey et al.,
2006) presents the Weighted Average Cost of
Capital (WACC) calculation as independent from the Free Cash Flow (FCF).
On the other hand, most studies state that WACC depends on value (but in practice
they do not take that into account) and they usually assume, a priori, constant leverage and calculate the WACC with that leverage. Apparently, they forget that leverage is equal to debt
divided by value. They do not recognize that keeping leverage constant implies some flows (to
repay debt or to acquire a new one) and only that particular debt policy makes the WACC
constant. Subsequent adjustments to the Cash Flow to Debt (CFD) and Cash Flow to Equity
(CFE) should be done, otherwise, WACC will not be constant and the valuation under
constant WACC assumption will produce inconsistent
results.
It is a common practice that practitioners calculate a WACC a priori and use it independently from the firm value (this is, from FCF) (see International Bank
for Reconstruction and Development - The World Bank, 2002). In this study, we show that
FCF affects WACC and that this interrelationship creates circularity; however, we also show
how it can be easily solved. |
