Are costs of capital necessarily constant over time and across states of nature?: Some remarks on the debate on ‘WACC is not quite right’

•WACC does not have to be constant over time. This is even true in absence of taxes.•Leverage decreases and operational risk increases are opposing effects on costs of equity.•Costs of capital may vary not only over time but also across the future states of nature.

Miller (2009a) opened a debate in this journal on the correct determination of weighted average costs of capital (WACC). So far Bade (2009), Pierru (2009a), Lobe (2009) as well as Keef, Khaled, and Roush (2012) have contributed to this debate. Even though they discuss the same, rather simple valuation problem, the dispute cannot be considered resolved. Whilst they agree that Miller erroneously assumed constant leverage ratios, the center of discussion is now placed on the question whether or not cost of capital is constant over time when leverage changes and interest paid is not tax deductible. In particular, Keef et al. (2012) demand time-invariant WACC and criticize Bade (2009) and Pierru (2009a) for allowing WACC to change over time. The aim of this paper is twofold. Firstly, we show that the arguments of Keef et al. (2012) are flawed and their criticism of Bade (2009) and Pierru (2009a) is thus unfounded. Keef et al. (2012) are wrong to ignore that not only financial risk but also operational risk can change over time. Secondly, we provide evidence that cost of capital can also be dependent on the future state of nature. So far this fact has been neglected by all contributors to this debate and becomes obvious only if state-dependent cash flow realizations, not only their expected values, are considered as well.