Target debt maintenance under alternative net present value specifications and implications for investment and finance decisions

Abstract

Two alternative specifications of weighted average cost of capital are prevalent in finance literature. Though both the specifications result in consistent accept/reject or ranking decisions the net present value arrived is different under each method. This paper traces the origin of this difference and resolves the same. It is shown that if projects are funded in such a way that resulting debt to equity is the optimal leverage then both specifications will yield identical net present values. In cases where such capital structure maintenance is not feasible there is loss of value due to unused debt capacity. We arrive at a lower bound for such a loss and also show that in such situations there exists a possibility of a synergy between projects which are otherwise independent.