James A. Miles, John R. Ezzell, The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification, The Journal of Financial and Quantitative Analysis, Vol. 15, No. 3 (Sep., 1980), pp. 719-730

The weighted average cost of capital (Ko) is presented in virtually all textbooks in financial management and capital budgeting as a practical concept fundamental to the actual selection of optimal financial and investment alternatives. As often employed Ko can be defined aswhereKo = the weighted average cost of capital, Ks = the cost of equity capital, Kb = the cost of debt capital, S = the market value of the firm's equity, B = the market value of the firm's debt, andV = S + B, the total market value of the firm.

Standard financial theory (in the absence of agency costs and personal taxes) implies that each dollar of debt contributes to the value of the firm in proportion to the firm's tax rate. To derive this result, incremental debt is assumed permanent. This paper shows that when the firm acts to maintain a constant market value leverage ratio, the marginal value of debt financing is much lower than the corporate tax rate. Since Hamada's [2] unlevering procedure for observed equity betas was derived under the assumption of permanent debt, we derive an unlevering procedure consistent with the assumption of a constant leverage ratio.

We use a unique set of equities in the when-issued market to provide new tests of the law of one price in financial markets. We compare the prices of when-issued and regular-way shares of publicly-traded subsidiaries and their parents around the time the subsidiaries are fully divested. In contrast to prior analyses of when-issued trading in equity markets, we find that the when-issued shares of the subsidiary trade at a discount. Some of the pricing differences stem from measurement factors such as exchange location and bid-ask clustering that bias the observed when-issued pricing differential away from zero. The remaining difference between the when-issued and regular-way prices is due to asymmetric movements in bid and ask quotes in the two markets. We also find evidence of temporary price pressures on the date of execution of the spinoff of the subsidiary firms that bear resemblance to the pricing in the when-issued market. We interpret the evidence as consistent with the law of one price in the presence of transaction costs.