2 questions

1.in MM II (No taxes), why would WACC be linear (flat) just because required return on equity is going up? I mean for example, when 100% debt is used, WACC should have no equity weighting and therefore should not be affected by the increasing required rate on equity. Am I missing something here? 2. Given r, required rate of return and q, the probability of the project failing in a certain year, the adjusted rate has the formula:

r* = (1+r)/(1-q) - 1 But I’m wondering why this is used instead of simply r/(1-q).

For example, if r = 60% and q = 80% first formulas gives [(1.6)/0.2] - 1 = 700%, but the other formula simply does 0.6/0.2 = 300% which makes intuitive sense to me (20% success, therefore we take r and times 5).

Please enlighten me!!


For (1) I would approach it from another angle:

MM Prop 1: The MV of a company is not affected by its capital structure.

Thus, if we have ten companies with identical Cash flows with all differing capital structures,

then we need all ten WACCs to be the same to compute the same MV.

Hope this perspective helps. =)

Regarding (2)

I try to remember the formula as

(1 + r*) (1 - q) = (1 + r)

If you have (1-q) probability of not failing, it requires a higher rate r^ to compensate for the probability of failing. You want to have a return of r, but there is some probability of failing. You need to require more, that is r*, to average out on (1 + r).

This is not how a professional would explain it, but it helps ME to remember the formula… and that r* must be larger than r, since the other factor is < 1.

Nice !

I have seen something like this for alts-regarding a venture firm failing, the formula is similar.