This paper examines the role of capital structure in project evaluation, arguing that financing decisions should be treated independently from investment decisions in accordance with the Modigliani-Miller theorem. It explains how the weighted average cost of capital (WACC) serves as the appropriate discount rate for net present value (NPV) calculations, how tax treatment of debt and equity affects the WACC, and when risk adjustments to the WACC are warranted. The paper also addresses the relationship between investors and shareholders, the conditions for project acceptance under NPV analysis, and the limited practical utility of the profitability index as a standalone decision-making tool.
The paper demonstrates applied theoretical reasoning — taking an abstract financial theorem (Modigliani-Miller) and systematically applying it to concrete decisions such as discount rate selection, tax shield valuation, and capital budgeting criteria. This technique is useful in finance and economics essays where principles must be grounded in real decision-making contexts.
The paper opens by establishing the independence of financing and investment decisions, then addresses the investor-company relationship, before building up to the mechanics of WACC and NPV. It transitions into nuanced discussions of tax effects and risk premiums, and closes with a critical evaluation of the profitability index. The argument flows from foundational principle to increasingly specific application, ending with a pointed critique of a commonly cited metric.
A project should not be evaluated in terms of its capital structure. The financing of a project is a decision that is independent of the decision to undertake the project. This principle flows from the Modigliani-Miller theorem, which holds that the choice of financing is irrelevant to the returns of an asset, all other factors being equal (Investopedia, 2012). The firm may have a preference for one type of financing over another, but those preferences are not part of the investment decision. Indeed, the firm's existing capital structure is already built into the weighted average cost of capital (WACC) calculation.
The distinction between the investor perspective and the company perspective is a false one. There is no meaningful differentiation or conflict between the two. The company exists to earn returns for its shareholders, and management acts as the agent of the shareholder with the objective of maximizing shareholder return (Kleiman, 2012). Thus, the investor and the company are one and the same. There is no meaningful distinction between them and no inherent conflict of interest.
Both the cost of debt and the cost of equity should be utilized when evaluating a project. The weighted average cost of capital should serve as the basis for the discount rate. As per the Modigliani-Miller theorem, the investment decision must be separated from the financing decision — in part because of opportunity cost, which may involve another project the firm is undertaking but would finance in a different way. By using the WACC, all company activity is treated consistently.
In theory, all projects with a positive NPV should be accepted. The exception arises when a company has limited resources and must choose among options; in that case, the project with the highest NPV should be selected (NetMBA.com, 2010). The WACC is the rate at which future cash flows are discounted to derive the net present value. Therefore, the higher the discount rate — that is, the higher the WACC — the lower the resulting NPV will be. In practical terms, this means the higher the firm's cost of capital (or opportunity cost of capital), the stronger a project must be in order to be accepted with a positive NPV.
You’re 35% through this paper. Sign up to read the remaining 2 sections.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.