Preliminary Draft, Please do not cite or circulate without author’s

permission

VALUING OPERATIONS: ADJUSTED PRESENT VALUE, MILES AND EZZEL

AND CAPITAL CASH FLOWS
- Abhilash S Nair, Associate
Professor, Finance, Accounting and
Control Area, IIM Kozhikode
abhilash@iimk.ac.in

BACKGROUND
Valuation in finance can be summarised as the sum of all the
risk adjusted benefits accrued and costs incurred over the
life of a asset. Put simply:

n
FCFt
Vt  
t 1 (1  rate)t

As we know, the estimation of the costs, benefits and risk

would depend on the view point with which the evaluation is
being done as summarised in the table 1:

Table 1: A summary of valuation approaches

Firm Valuation Cost Total Investments
View point of all Benefit Free Cash Flows to
investors Firm
Risk Weighted Average Cost
of Capital
Equity Valuation Cost Equity Investments
View point of Benefit Free Cash Flows to
equity investors Equity
Risk Cost of Equity

As seen earlier, financial leverage affects risk perception.

Generally, equity valuation approach does not adjust for the
enhanced risk perception of equity investors as a result of
borrowing. Hence, for most practical purposes, a firm
valuation approach is adopted. In this approach, the future
costs and benefits over the life of the asset are discounted
at WACC. The WACC is kept constant for the entire life of the
asset, assuming that as in the MM world (without taxes), the
market value weights would so adjust itself that the hurdle
 Preliminary Draft, Please do not cite or circulate without author’s
permission

rate would remain constant irrespective of the capital

structure. Let’s understand this through a illustration:

Gedankenexperiment: Pumba Enterprises, is into the business of

deworming the world. The hurlde rate of similar firms which
are unlevered is 15%. The initial investment is $500 of which
$300 is equity and $200 is debt borrowed at 10% rate of
interest. One year later, the firm is doing well and needs to
expand for which it needs $400 more. The firm borrows the
entire amount. The market value of equity now is $400 and the
value of debt is $600. There are no taxes.

Scenario 1: Initially, the firm is financed using $300 of

equity and $200 of debt, the WACC can be estimated as follows:
Levered cost of equity=15%+(200/300)(15%-
10%)=18.33% and the WACC=0.6*18.33%+0.4*10=15%

Scenario 2: The expansion related investment of $400 is

invested after one year. The entire investment is borrowed and
invested. The updated cost of equity is:
Levered cost of equity=15%+(600/400)*(15%-
10%)=22.5%
and the associated WACC is given by
WACC=0.4*22.5%+0.6*10%=15%
It may be noted that despite the change in costs, the WACC
remains the same since the weights adjust for the change in
risk perception.

In the above example we assume absence of taxes. However, if

the firm follows a constant proportion of debt capital
structure policy, WACC remains constant even in the presence
of taxes.
Thus, WACC works in a world where debt is continuously
rebalanced and there are no exotic debt instruments. It also
subsumes all effects of any government subsidy on investment,
taxes etc., any issue related costs, any financial distress
and most of all the tax shields. A more refined way of
evaluation is the use of Adjusted Present Value.

ADJUSTED PRESENT VALUE

APV breaks the value of an asset into the value created by
decisions pertaining to the firm’s operations (hereafter
called business decisions) and the value created by financial
 Preliminary Draft, Please do not cite or circulate without author’s
permission

decisions (hereafter called financial side effects). To

ascertain the former, APV assumes that the business is
financed entirely by equity. The value so created (through
business decisions) is called ‘base case’ value. The later,
manifests in multiple forms such as: (i) Cost of raising
capital, (ii) Cost of Financial distress, (iii) Cost and/or
Benefit of Hedging, (iv) Cost and/or benefits through use of
hybrids and other exotic instruments to raise capital, (v)
Benefits of a tax holiday or investment subsidy etc.

Value assuming Financial Side Effects

APV = the project is +
1. Interest Tax Shield
financed entirely
2. Issue Cost
by equity
3. Cost of Financial Distress
4. Cost/Benefit of Hedging
5. Cost/Benefit of exotic
instruments
6. Benefits from a
Investment subsidy of tax
Base Case Value holiday

Gedankenexperiment (continued)
Say Pumba enterprise is a company which would be wound up
after one year for no residual value what so ever. The initial
investment remains the same $500 ($300 of equity and $200 of
debt). At the end of the year, the firm generates operating
profits worth $ 900. The unlevered cost of equity for similar
firms is 15% and the cost of debt is 10%. Tax rate is 30%.
Appraise the business proposal following the NPV approach and
the APV approach.

Step1:NPV
As shown earlier, the levered cost of equity is 18.33% and
hence the WACC (in the presence of taxes) is given as: WACC=
0.6*18.33%+0.4*10*(1-0.3)=13.8%
Hence, the value of this firm is $ 553.60 and it’s NPV=
53.60

Step 2: NPV(APV)
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Firstly, the base case value is given by 700*(1-

.3)/1.15=547.83
I
n this case, interest tax shield is the only financial side
effect, hence, the value of financial side effect = D*Kd*T
(200*10%*30%)=6 discounted for one period at Kd i.e.
6/1.1=5.45

Thus, Adjusted Present Value=547.83+5.45=553.3

And, NPV(APV)=53.3

In this case, since there are no exotic debt instruments,

the value of the firm using WACC and following APV is more
or less the same. The benefits of APV are: (i) It unbundles
value creators i.e. to say that you get to know what
decisions were responsible for creating value, (ii) It is
flexible, one can unbundle and adjust the risk of each value
creator differently. More details will be discussed in
subsequent sections. Thus, it can be said that APV will
perform atleast as well as WACC.

VALUING FINANCIAL SIDE EFFECTS

INTEREST TAX SHIELD (ITS)

In the presence of taxes, ITS is an important incentive to
borrow and resultantly a important financial side effect.
However, the opinion on what is the risk of ITS or the
appropriate discount factor for ITS is debatable. While,
Copeland et.al. (2000 pg. 483) says that literature is
ambivalent or unclear regarding the discount rate for ITS
others, like Harris and Pringle (1985), Miles and Ezzel
(1981)have tried to assign a discount rate to ITS depending on
the capital structure policy. We discuss four different
capital structure policies:

Constant Debt (Amount of debt is constant)

This is the simplest formulation and as one would expect with

the strongest assumption. In this case, the amount of debt
does not change for the entire life of the project/firm.
Hence, the risk of benefiting from interest tax shield is the
 Preliminary Draft, Please do not cite or circulate without author’s
permission

same as the risk of servicing the debt1. In other words, ITS is

believed to be as risk as interest payment and hence, is
discounted at cost of debt.

Illustration
The Loosent Company has prepared a forecast of
free cash flows for a project. The company
plans to finance the project in part with
debt. The level of debt that will be used has
also been determined. This information is
shown below.

Particulars\Year 0 1 2 3
FCFF -100 50 100 70
Debt (beg of year) 46.465 37.91 16.13

The Company’s cost of equity is 10%. It has a

market capitalisation of Rs. 10.8 billion and
a Enterprise value of Rs. 14.4 billion2.The
Cost of Debt is 6.1% and the corporate tax
rate is 35%.Calculate the value of the project
following WACC approach and APV approach?

Solution-Valuation following WACC approach

The project satisfies the condition for using

the WACC method: the firm maintains a constant
debt to equity ratio; and since the project's
overall risk is similar to that of the risk of
the company itself, the company's WACC will be
the appropriate discount rate. Using the
provided information, the WACC is calculated
as follows.

WACC=(E/V)Ke+(D/V)Kd(1-Tc)

1
While we do agree that there can be situations where the company pays
interest but still cannot enjoy ITS due to lack of profits in a particular
year, in most economies such losses can be carried forward and offset
against future profits. Hence, we assume that if a company pays interest,
it will enjoy ITS.
2
The Enterprise Value is the value of underlying business other after netting out cash and marketable
securities.
Preliminary Draft, Please do not cite or circulate without author’s
permission

= (10.8/14.14)0.10+(3.6/14.14)*0.061*0.65
= 0.08491
Applying this hurdle rate, the value of the
project is:
0 1 2 3
FCFF -100.00 50.00 100.00 70.00
Debt (beg of 46.47 37.91 16.13
year)
Firm Value 185.86
NPV 85.86
Thus, the value of the project following WACC
approach is Rs. 185.86.

Valuation following APV approach

The project satisfies the condition for using

the APV method: the level of debt the company
intends to maintain for the project is
provided. This is all that is known of the
company's debt policy. There are two steps to
the procedure. First, the base case value has
to be determined. Second, the interest tax
shields have to be calculated and their
present value has to be computed.

Loosent’s Base Case Value: To estimate the

base case value, first calculate the unlevered
cost of equity.

Ka=(E/V)*Ke+(D/V)*Kd
=(10.8/14.14)0.10+(3.6/14.14)*0.061
=9.025%

0 1 2 3
FCFF -100 50 100 70
Base Case Value 184

Discounting the cashflows at 9.025%, the

project’s base case value is Rs. 184.

Value of Loosent’s Interest Tax Shields

(Financing rule 1): Given the predetermined
levels of the debt during the project's life,
we can calculate the interest tax shields.
Preliminary Draft, Please do not cite or circulate without author’s
permission

Note that the interest tax shield associated

with debt in period t is obtained in the
period t+1. Finally, note that since these tax
shields are based on predetermined debt
levels, their risk is the same as the debt
itself and hence the discount rate is Kd. The
calculations are shown below.

0 1 2 3
Debt (beg of 46.47 37.91 16.13 -
year)
Interest Paid 2.83 2.31 0.98
ITS 0.99 0.81 0.34
Value of ITS 1.94

APV of Loosent: The value of the company is

the base case value plus the present value of
the interest tax shields. This is Rs. 185.94.

Value of Loosent’s Interest Tax Shields

(Financing rule 2):
Under this formulation/specification, the
amount of debt in a firm is being continuously
rebalanced such that the Debt to Firm value
ratio remains constant. The firm value is
first estimated following the traditional WACC
approach. Assuming that the increase in firm
value is due to an increase in activity
(production, marketing etc.), there is a need
for additional capital. This capital is raised
so as to keep the debt to firm value ratio
constant. As a result, the amount of debt that
the firm will borrow starts assuming business
risk. The ITS is now riskier than the credit
risk of debt (because of the variability).
Thus the ITS is discounted at Ka rather than
Kd. The value of firms following financing rule
2 arrived at following WACC and APV approaches
are the same (Proof 2 at the end of this
chapter). Thus, a simple way to estimate the
Preliminary Draft, Please do not cite or circulate without author’s
permission

value of ITS would be to deduct the base case

value from the firm value arrived at using
WACC. In case of Loosent, this amounts to Rs.
1.86 (185.86 minus 184). By now you may have
realised that the value of ITS going by
financing rule 2 is lesser than that estimated
following financing rule 1. This is so
because, under financing rule 2 ITS is
discounted at a higher rate, the unlevered
cost of equity so as to capture the business
risk embedded in the forecasted Debt amounts.
Whereas in financing rule 1, ITS is discounted
at a lower rate, the cost of debt. Assuming
that only the credit risk matters given that
you know the amount of debt with certainty.
The next section details the estimation of ITS
and the value of ITS following financing rule
2.

Example (Loosent Company continued...)

The Loosent Company has prepared a forecast of
free cash flows for a project. The company
plans to finance the project in part with debt
and the level of debt that will be used has
also been determined (see below). However,
note that company is presently following a
leverage policy of maintaining a constant
debt/equity ratio of 1/3.

0 1 2 3
FCFF -100 50 100 70
Debt (beg of 46.47 37.91 16.13 -
year)

The company's cost of equity capital is 10%.

It has a market capitalization of $10.8
billion, and an enterprise value of $14.4
billion. The enterprise value is the value of
the underlying business assets separate from
cash and marketable securities. This is what
it would cost to buy up all of the outstanding
equity and the debt. The cost of debt is 6.1%.
Preliminary Draft, Please do not cite or circulate without author’s
permission

The tax rate is  = 35%.Calculate the value of

ITS for this project.

Solution
To estimate the ITS for each year, we need to
first estimate the amount of debt for which
the firm value in each year, given information
at time t=0, needs to be estimated.

Given that the capital structure policy is to

maintain a constant debt equity ratio of 1/3,
following the WACC approach the firm value
obtained, Rs. 185.85, as is shown above. This
is the value at time 0 of sum of the FCFFs in
periods 1, 2, and 3.

At each instant of time the firm will adjust

its debt level to match the change in the
value of the firm. Remember the project is
adding value each period. At time 0 we know it
is adding V0= 185.85. Thus to maintain a debt-
equity ratio of 1/3 which is a debt ratio of
D/V = 0.25, Loosent must increase its debt at
time 0 by 25% of the value added by the
project:

D0=0.25*185.85=46.4625

What about the adjustments in the future

periods? We need to know the value of the
project in each period to calculate the level
of debt that has to be added to maintain the
constant debt ratio. Note that we are actually
talking about incremental debt, because this
is the new debt that is added. This amount of
debt in each period that is required to be
added to maintain constant debt ratio is
called debt capacity. The debt capacity is
calculated as follows,

Dt=d*Vt

Where, d is the constant Debt to Value ratio.

The value of the project at each time is given
Preliminary Draft, Please do not cite or circulate without author’s
permission

by the expression above. So we have to

calculate the value of the project at each
point in time and then calculate the debt
level. This is shown below.

Once we know the value of the firm at each

point in time, the value of the debt is just
the debt ratio multiplied by the value of the
firm. This is also shown in the table.
Particulars\Year 0 1 2 3
Value for the 0th Year
FCFF -100 50 100 70
PV Factor 1 (1.085)-1 (1.085)-2 (1.085)-3
PV FCFF 46.09 84.96 54.80
V0 185.85
Value for the 1st Year
FCFF 100 70
PV Factor (1.085)-1 (1.085)-2
PVFCFF 92.17 59.46
V1 151.63
Value for the 2nd Year
FCFF 70
PV Factor (1.085)-1
PVFCFF 64.52
V2 64.52
Debt Schedule
Debt=0.25*Vt 46.4625 37.91 16.13 -

Once we know the value of the firm at each

point in time, the value of the debt is just
the debt ratio multiplied by the value of the
firm. This is also shown in the table.

Secondly, based on the amount of debt borrowed

at the beginning of each period, the ITS at
the end of each period is forecasted and
discounted at unlevered cost of equity.

Present Value of ITS

The calculations are shown below. The discount
rate is Ka = 9.025%
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Particulars\Year 0 1 2 3
Project Debt 46.465 37.91 16.13 -
Interest (Kd=6.1%) 2.834 2.3125 0.98393
ITS 0.99201 0.8094 0.34438
PV Factor (1.09025)-1 (1.09025)-2 (1.09025)-3
Present Value of each ITS 0.910 0.681 0.266
PV(ITS) 1.85671

Comment
Both, financing rule 1 and 2 are equally
constraining on the projected debt schedule.
While financing rule 1 assumes no change in
debt schedule. Financing rule 2 assumes that
the debt is being rebalanced at every point in
time. This would lead to huge transaction
costs. A more practical approach would be to
assume that the capital structure is Adjusted,
once in the beginning of the year, also known
as the Miles and Ezzel (1980) approach.

Adjust the amount of debt once a year at the beginning of the

year (Miles and Ezzel, 1980)

Continuously rebalancing Debt to keep the Debt to value

proportion constant is a very strong assumption, the
transaction costs would be prohibitively high. Hence, a more
plausible assumption is of rebalancing once in the beginning
of the year. In doing so, each ITS is certain for the first
year and thereafter uncertain due to rebalancing.

1  Ka
K *  K a  K d * L * tc ( )
1  Kd

You may have realised that the Miles and Ezzel approach
actually adjusts the WACC to accommodate the assumption on
capital structure. As in WACC, the ITS is actually subsumed in
the firm value. A detailed proof of the Miles and Ezzel is
given in proof 3 and 4 at the end of this chapter.

Example (Repeated) The Loosent Company has forecasted the

following free cash flows for a project. This is a typical
project for Loosent; its risk is similar to Loosent's overall
business risk.
 Preliminary Draft, Please do not cite or circulate without author’s
permission

0 1 2 3
FCFF -100.00 50.00 100.00 70.00

The company maintains a constant debt equity ratio which is

adjusted once a year at the beginning. The company's cost of
equity capital is 10%. It has a market capitalization of Rs.
10.8 billion, and an enterprise value of Rs. 14.4 billion. The
enterprise value is the value of the underlying business
assets separate from cash and marketable securities. This is
what it would cost to buy up all of the outstanding equity and
the debt. The cost of debt is 6.1%. The tax rate is = 35%.
Solution

The project satisfies the condition for using the $WACC_ME$

method: the firm maintains a constant debt to equity ratio,
which is rebalanced once a year at the beginning. Using the
information provided, the WACC_ME is calculated as follows.

 1  Ka 
WACCME  Ka  Kd * L * Tc  
 1  Kd 
=0.0925-0.061*0.25*0.35*(1.09025/1.061)=0.0848.

0 1 2 3
FCFF -100 50 100 70
ME WACC 8.48%
Value as per 185.91
ME WACC
ITS 1.91

Thus, the value of the project is 185.91 and

the ITS is 1.91.

Takeaway
It may be noted that the ITS as per WACCME
would be higher than that estimated using WACC
because while in WACC approach all ITS is
discounted at Ka, in the ME approach, as shown
in figure 1, each ITS is discounted at Kd for
the first year and thereafter at Ka.
Similarly, the value of ITS as per MEWACC
 Preliminary Draft, Please do not cite or circulate without author’s
permission

would be lower than the ITS following fin rule

1.

CAPITAL CASH FLOWS (RUBACK, 2002)

The capital cash flows approach to valuing investments was put
forth in Ruback (2002) as an alternative to overcome the
strong assumption of constant proportion of debt as in the
WACC approach or in the APV approach following financing rule
2.

“...Because the WACC is affected by changes

in capital structure, the FCF method poses
several implementation problems in highly
leveraged transactions, restructurings,
project financings, and other instances in
which capital structure changes over time...”

In the CCF approach, the cash flows include all cash flows
available to capital providers, including the interest tax
shield. In a way, deducting interest from operating profits
(EBIT) not only reduces the taxable income (to the extent of
interest paid (I)) and as a consequence the tax liability (to
the extent of tax shield (Interest paid*tax rate) but also the
post tax profits. Thus, CCF can be described as FCF plus the
value of interest tax shield. In a capital structure with only
debt and equity, CCF would be equal to cash flows available to
equity (FCFE). The appropriate discount factor to accommodate
the risk of CCFs is Ka. The value so obtained will be the same
as that obtained following WACC or following APV assuming
financing rule 2 (Proof 5 at the end of the chapter).

= Depreciation - + Interest
CCF PAT + - Capex ∆NWC
and other non Paid
cash expenses

Illustration Loosent Technologies (contd...)

Assuming that the Depreciation is equal to the
sum of capex and NWC. We can estimate the
operating profit (EBIT) for the firm by
 Preliminary Draft, Please do not cite or circulate without author’s
permission

dividing the EBIAT by (1-taxrate) and then

estimate CCF.
CCF 0 1 2 3
EBIT -100 76.92 153.85 107.69
Interest 2.83 2.31 0.98
EBT 74.09 151.53 106.71
Tax 25.93 53.04 37.35
PAT 48.16 98.50 69.36
CCF 50.99 100.81 70.34
Firm Value 185.86

Discussion: It may be noted that, in the case of Loosent,

the CCF gives you a value no different than WACC or APV (Fin
Rule 2). Based on MMs assumption that the cost of equity will
change in proportionately to the change in debt
[Ke=Ka+(D/E)(Ka-Kd)] Ruback states that

“The CCF method retains its simplicity when

the forecasted debt levels and the implicit
debt-to-value ratios change throughout the
forecast period. Also, the expected asset
(unlevered cost of equity) returns depends on
the riskiness of the asset, therefore, does
not change when the capital structure changes.
As a result, the discount rate for CCFs does
not have to be re-estimated every period.”..
We believe, that at the time of appraisal (at
t=0), WACC, APV(Fin Rule 2) and CCF would
assign the same value to a given investment.
The only difference being that in WACC and CCF
the value of ITS is ‘subsumed in the firm
value’ and APV gives it out explicitly. The
rest we believe is semantics!!

OTHER FINANCIAL SIDE EFFECTS

INVESTMENT SUBSIDY

FINANCIAL DISTRESS

ISSUE COSTS

Appendix: Sketch of some essential proofs to important results

that we shall use in this chapter and later.
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Proof I: Levering and Unlevering in the presence of taxes

Background: MM proposition 1 under certain conditions

(assumptions of MM) value of the firm is independent of its
capital structure. Their second proposition explains the
increase in threat perception of the equity investors as the
firm borrows money. Among other things they assume that there
is no corporate tax. However, in reality there are taxes.
Given below is the impact of financial leverage on the
expected returns of equity investors in the presence of taxes.

As per MM proposition 1, the balance sheet of a levered firm

can be shown as below:

Liability Asset
Market Value of Debt (D) Value of the unlevered
firm`(Vu)
Market Value of Equity (E) Value of tax shield (Tc*D)

Balance sheet is a stock concept which is prepared mostly

annually. To ensure absence of arbitrage, the cash flows at
every point in time should match. In other words, cash flows
from the LHS (liability side) and the RHS (Asset side) should
match. The expected cash flows on the RHS of the balance sheet
can be written as: Vu*Ka+Tc*Kd*D, where Vu is the unlevered firm
value, Ka is the unlevered cost of equity, Tc is the corporate
tax rate, Kd is the cost of debt and D is the book value of
debt. Similarly, the expected cash flows from the LHS is given
as: E*ke+D*Kd, where Ke is the levered cost of equity and E is
the market value of equity,

Vu*Ka+Tc*Kd*B= E*ke+D*Kd (i)

From the balance sheet we can write:

Vu=E+D- Tc*D (Value of taxshield taken to perpetuity at cost of

debt) (ii)

Substituting (ii) in (i) and making Ke the subject of the

expression, we get:

Ke=(1+(D/E)-(D/E)*Tc)*Ka+(D/E)*Kd*Tc-(D/E)*Kd

=Ka+(D/E)*(Ka-Tc*Ka+Tc*Kd-Kd)

=Ka+(D/E)*(1-Tc)*(Ka-Kd) (iii)

On rearranging (iii) we can see that it is the same as WACC

 Preliminary Draft, Please do not cite or circulate without author’s
permission

We*Ke+Wd*Kd*(1-Tc), were We=(E/(D*(1-Tc)+E) and Wd=(D/(D*(1-

Tc)+E).

We have just proved that the value of a firm that designs its
capital structure following financing rule 2 (ie. Borrow or
issue equity so as to keep the Debt to value ratio constant at
every point in time) is the same as
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Proof II: Equivalence of Value estimated following APV and

WACC if the firm follows Financing Rule 2 in order to manage
its capital structure

Background: If a firm follows financing rule 2 to manage its

capital structure, then its Interest tax shield would keep
varying with the firm value. Hence, the ITS assumes business
risk which is why it is discounted at the unlevered cost of
equity and not the cost of debt. The firm value (base case
value plus ITS), so obtained, is the same as the firm value
obtained by discounting free cash flows to firm with WACC.

Proof: Value of a firm to perpetuity is given as:

FCFFt  1
Vt 
WACC

FCFFt  1
=
D E
(Rf  d R p(1  Tc)  (Rf  eR p)
V V
FCFFt  1
=
 D(1  Tc) R  E R    D(1  Tc)  R (1  T )  E  R 
 f  e p
   
f d p c
V V V V
FCFFt  1
=
 D  E  R  TcDRf   D  R  E  R   D T  R
  f  e p
V V V 
d p c d p
V V V

FCFFt+1
=
TcD D
(1  )Rf  (a  dTc)R p
V V
FCFFt+1
=
DTc
Rf  aR p  (Rf  d R p)
V
FCFFt+1
V =
DTc
Ka  Kd
V
VKa  FCFFt  1  DTcKd
FCFFt+1  DTcKd
V =
Ka

We started with firm value as estimated by discounting the

free cash flows to firm with WACC and we have arrived at the
Value of the unlevered firm plus the interest tax shields
discounted at Ka.
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Financing Rule 1 is impractical since it assumes that a firm

borrows once and that level of borrowing is kept constant to
perpetuity. Financing Rule 2, is equally constraining when it
assumes that the firm continuously rebalances its capital
structure so as to maintain a constant debt to value ratio. An
adjustment to financing rule 2 is made by assuming that the
firm adjusts its capital structure once a year at the
beginning. Hence, by adjusting capital structure once a year,
the transaction costs are minimised. This is the Miles and
Ezzel (ME) extension to Financing Rule 2. Given below is the
proof of the ME extension. The proof is in two parts, first we
prove ME in the context of a single period and then we extend
it to multiple periods.

Proof III: ME in a single period context

Since, this is a single period case, in the beginning of the

period the amount of debt is known. Hence, the interest tax
shields are as risky as the debt and can be discounted at Kd.
Thus, the value of a firm can be written as:

FCFFt  1 T * Kd * Dt
Vt   c (1)
1  Ka 1  Kd

FCFFt  1
Say there exists a discount factor K* such that Vt  .
1  K*
Note that the interest tax shield is built into the K*.

Let L be the constant Debt to Value ratio (1) can be rewritten

as:

FCFFt  1 T * Kd * L * Vt
Vt   c
1  Ka 1  Kd

Rearranging terms we get

 (1  Ka)
Vt 1  Ka  Tc * Kd * L *   FCFFt  1
 (1  Kd)

(1  Ka)
Let K*  Ka  Tc * Kd * L *
(1  Kd)

FCFFt  1
Thus, Vt 
1  K*
 Preliminary Draft, Please do not cite or circulate without author’s
permission

K* is the ME adjusted discount factor, it already subsumes the ITS.

It helps us relax the assumption of continuous rebalancing to
rebalancing once in the beginning of the year.

Proof IV: Multi period proof of ME adjusted hurdle rate.

As stated in proof 1, as per MM proposition 1, the balance

sheet of a levered firm can be shown as below:

Liability Asset
Market Value of Debt (D) Value of the unlevered
firm`(Vu)
Market Value of Equity (E) Value of tax shield (Tc*D)

As reasoned earlier, to ensure absence of arbitrage, expected

returns of investors in the firm and the expected returns of
the firm in assets must be the same at every point in time.
The expected returns from RHS is:
Vu V
Ka  ITS KITS
V V

Vu V E D
Ka  ITS KITS  Ke  Kd
V V V V

E  V  VITS D
Ke   1  ITS  * Ka  KITS  Kd
V  V  V V
 V  D V
WACC   1  ITS  * Ka  * Kd * Tc  ITS KITS
 V  V V
D V
= Ka  * Kd * Tc  ITS KITS
V V

E D
Ke  WACC  Kd(1  Tc)
V V , where VITS stands for
the value of the interest tax shields taken to perpetuity, KITS
is the expected returns of investors from Interest tax
shields. Similarly, the expected returns from LHS is:
E D
Ke  Kd .
V V

Vu V E D
To ensure AoA, Ka  ITS KITS  Ke  Kd (i)
V V V V
 Preliminary Draft, Please do not cite or circulate without author’s
permission

We know that by definition Vu=V-VITS,substituting this is (i) we

E  V  V D
get: Ke   1  ITS  * Ka  ITS KITS  Kd (ii)
V  V  V V

E D
Given that by definition WACC is: Ke  Kd(1  Tc), we can say
V V
E D
that: Ke  WACC  Kd(1  Tc) (iii)
V V

Equating (ii) and (iii) we get:

 V  D V
WACC   1  ITS  * Ka  * Kd * Tc  ITS KITS
 V  V V

D V
= Ka  * Kd * Tc  ITS (Ka  KITS) (iv)
V V

By formulation, the ME capital structure is adjusted once in

the beginning of each year. As a result, the CFs, the KITS and
(VITS/V) will be different for each period. However, the
product of (KITS-Ka)*(VITS/V) will remain constant. This
condition is met by the ME rebalancing policy.

Given this rebalancing policy, at least, for each year, the

amount of debt is know for sure in the beginning of that year.
Hence, the ITS for that year could be discounted at Kd.

TcKdLVt V
VITS,t   ITS,t  1 (v)
1  Kd 1  Ka

By definition,

TcKdLVt  (VITS,t  1  VITS,t)

KITS  (vi)
VITS,t

Expanding and rearranging (v) gives

VITS,t  1  VITS,t T K LV  1  ka 
 Ka  c d t  
VITS,t VITS  1  kd 

LVtKdTc
Adding to both the LHS and the RHS and comparing the
VITS,t
LHS to (vi), we can write (v) as:

TcKdLVtKa TcKdLVt LVtKdTc

KITS,t  Ka   
VITS,t(1  Kd) VITS,t(1  Kd) VITS,t
 Preliminary Draft, Please do not cite or circulate without author’s
permission

Simplifying and rearranging terms gives us:

VITS,t TK L
(KITS,t  Ka)  (Kd  Ka) c d t
Vt 1  Kd

Substituting this in the WACC equation (iv), we get:

 1  Ka 
WACC  Ka  LKdTc  .
 1  Kd 

Proof 5: Equivalence of valuation following Capital Cash flows

and following WACC.

Background: CCF, just as in firm valuation using WACC,

measures the cash available to all providers of capital.
However, unlike firm valuation, it does not adjust the hurdle
rate to capture the tax shields. Instead, it adjusts the
taxshields in the cash flow estimates itself. In a capital
structure with ust ordinary debt and common equity, CCF
equals:

CCF=PAT + Depreciation – Capex –NWC+ Interest Paid

Note the difference, the cash flows for the debt providers is
the interest paid and for the equity investors the rest.
Further, unlike in firm valuation using WACC, CCF is
discounted at the unlevered cost of equity Ka.

Proof: Assuming that the Depreciation= Capex +NWC, firm value

EBIT(1  Tc)
using WACC, is given as: ,
WACC

Given the background to CCF above, it can be easily seen that

CCF=EBIT(1-Tc)+KdDTc

Accordingly, the value of the same firm following CCF is given

EBIT(1  Tc)  KdDTc
as: .
Ka

Assuming (i) cost of equity and cost of debt to be defined as:

Rf+b(Rm-Rf); and (ii) that debt is risk free (in other words
debt b =0) and expressing be in terms of ba (be=(V/E)* ba) we
can define the value following firm valuation using WACC as:
EBIT(1  Tc)
V 
   
D Rf(1  t)  E (Rf  V aR p)
V V E  
 Preliminary Draft, Please do not cite or circulate without author’s
permission

On expanding the terms we can write the value as:

EBIT(1  Tc)  RfDTc
which is the same as the value following CCF.
Ka