Document Type

Working Paper

Publication Date

7-13-2022

Abstract

I examine the effects of cash-flow risk resolutions on project valuation by deriving risk-resolution-scenario-specific "families" of capital structure relations (i.e., equations for the value of the levered firm, return on levered equity, and marginal cost of capital). Although I obtain Modigliani and Miller’s family of relations only as highly constrained special cases reflecting "risk-free" cash flows, I find that their qualitative insights into firm value and leverage in the presence of corporate taxes are robust across the cash-flow risk resolution scenarios examined. More practically, I find that analysts will correctly value a scale enhancing project (i.e., a project of the same risk class as the firm funded at the firm’s observable leverage ratio) by discounting its net cash flows at the firm’s observable weighted average cost of capital regardless of the actual way the project’s cash-flow risk actually resolves. However, analysts will misvalue projects involving changes in leverage ratio if they use a weighted average cost of capital implied by a family of capital structure relations inconsistent with the way the project’s cash-flow risk resolves (e.g., valuation errors result when analysts use Modigliani and Miller’s marginal cost of capital in the real world). Employing standard alternatives to traditional weighted average cost of capital valuation (e.g., Myers’ APV and Ruback’s Capital Cash Flow approach) does not solve this problem). More generally, I show that practitioners best not approach project (or firm) valuation with a one-size-fits-all or favorite set of valuation equations. Rather, they must be guided by their best understanding of the way the project’s cash-flow risk resolves, hope that understanding is correct, and employ the family of relations consistent with that understanding.

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