Hello,
why do we use WACC as a discount rate?
Why not the rate of return of an alternative investment with similar risk profile?
Assumed I am valuing a company, we discount our future earnings with the costs of capital. Aren’t the costs of capital allready in the earnings included? Furthermore, why then WACC on the profits instead of invested capital?
I don’t get it.
Best regards
In which other manner you can discount the value of entire company than using avr weighted cost of each component of its source of financing. If you use another approach by discounting only the equity capital, then you may use only equity cost as discount factor, r.
Of course you may use the alternative ways to valuation as mentioned using of comparables. Such approach also requires adjustments and might not be an easier manner of valuation.
However, whether the valuation is the part of Level 1 curriculum?
You have to discount the cashflow for the discount rate because you have to take into account the time value of money for the future cashflow. That is why one dollar you have at present day is worth more than 1 dollar you have in one year because you can always invest 1 dollar and get the principal and interest one year later. The discount rate represent the time value of money plus all the risk associated with the money invested, including default risk, liquidity risk, maturirty risk. For the other question, yes, you can always use the rate of return for other investment with similar risk. However, it is hard to find an exact investment with exactly the same risk as different institutes have different risk structure and therefore, different rate of return.
You could use the Req’d Rate of Return of an alternate investment with the same risk profile, but the question is how you identify it.
When you calculate WACC, you’re calculating the RROR for the “average risk project” of the firm. Here’s why: if you had a market for projects, you could back out the required rate similarly to the way you calculate the YTM or cost of equity.
But you don’t, so you can’t.
However, calculating WACC does just that.
If you bought all the firm’s debt and equity, you’d receive all the after-tax cash flows of the firm. That means that this value-weighted portfolio of the firm’s debt and equity has the same profile of cash flows as the “average” project of the firm. So it must also have the same required rate of return as the “average” project of the firm.
Of course, if your project is more (or less) risky than average, you have to make adjustments. But that’s another issue.
You discount CASH FLOWS, not PROFITS. remember that profits are an accounting construct, and are different from cash flows.
The discount rate you use must be consistent with the cash flow used: if you’re using the unlevered cash flows from the project (basically, this is the incremental Free Cash Flow to the Firm (FCFF) from the project, you use the cost of capital. If you’re using a post-leverage cash flow (basically, Free Cash Flow to Equity), you use the cost of equity.
That same concept (matching cash flow to discount rate) also comes up in the valuation section, so it’s worth remembering.
Thanks to everyone!
Especially busprof, brilliant explanation! That’s what I was looking for.
You’re welcome. Glad it was helpful.
One question have came up again: Why do we discount the FCF instead of considering the WACC on our invested capital? Sorry, I didn’t find the answer above to get it.
Assumed we invest $100 in a project and we will get $10 (unlevered FCF) the three years after.
t0: (100) t1: 10 t2: 10 t3: 10
Supposed the WACC is 5%.
If we discount our t1 FCF with WACC 5%, we will get a present value (t1 FCF) of 9,52$.
But if we pay the 5% costs of capital on our $100 invested capital after one year, we need to pay $5. So the t1 FCF goes down effectively to $5 instead of $9,52.
That’s the point I don’t get. In our DCF Analysis we put the WACC on our FCFs. But doesn’t the WACC need to correspond to the invested capital?
Where is my fault in thinking?
Nobody?
The $5 cost you’re talking about is already captured in the WACC calculation as (Kd). You will be double counting if you subtract the $5.
To make this clear, try using cost of equity (ke) as a discounting factor. You will get a different number (unless the company is debt-free) and that number isn’t capturing the cost of financing.
You could use different discounting methods such as the return you’re requiring. However, it will not be efficient to do so if the return you are requiring less than the cost you are incurring from raising the capital needed. On the other hand if your required rate is so high (for example 50%), you will get a low price but you not find a seller at that level.