On the Theoretical Foundation of Corporate Finance

On the Theoretical Foundation of Corporate Finance

Many years ago, I was learning corporate finance for the first time. I was amazed by the elegance and generality of the formula for WACC (Weighted Average Cost of Capital). Cashflows and capital structures have various patterns. Yet a single formula captures them all. It was also a surprise for me. WACC is a linear combination of two (or more) discount rates. Yet discounting is a nonlinear factor. How can a nonlinear factor be represented by a linear formula? I was driven to read the original 1958 paper of Modigliani and Miller that set the whole foundation of corporate finance.

In that paper, Modigliani and Miller derived the WACC formula from a very special case. All expected cashflows are constant to perpetuity. Is Modigliani and Miller theory valid for more general cases?  However, I didn’t pursue the topic further. After all, the theory has been taught worldwide for many years. It can’t be wrong.

As a finance teacher, I need to teach Modigliani and Miller theory again and again. Every time I teach the formula of WACC, I feel uncomfortable going over something I don’t understand. In the end, I sat down to derive the whole thing for general cashflows and capital structures. It confirms my intuition. Modigliani and Miller theory is not valid for general cashflows and capital structures. This means WACC systematically misprice assets, sometimes substantially. This result has significant impacts for the teaching and research of finance, for the theory and practice of finance.

It is not easy to publish a paper against a theory that is considered universal truth, a theory that is taught to all finance students. After many years, the work is finally published. The paper can be accessed from the publisher before Nov 2 by clicking the following link,

https://authors.elsevier.com/a/1dkhl,LimiaC1f

Thanks for your kind attention.