Adjust Cash flow or Adjust WACC?

In case of country risk , inflation or other kind of risks. I am so confused. don’t know whether should adjust WACC or cash flows.


Generally speaking, it’s one or the other. Country risk for example, you capture this risk in A.) the cash flows or B.) the WACC - but not both. You will be double counting (for lack of a better term) the risk if you capture the risk in both, thus undervaluing.

The decision of which input (WACC or cashflows) to adjust is the question, and usually comes down to how accurately you can capture the risk. Adjusting the cash flows is normally preferred bc it is more explicit. Adjusting the WACC (cost of equity) is also ok, but is more subjective.

Inflation is interesting. Inflation is a risk but it bucks what i said previously regarding one or the other. This is because you have to match apples-to-apples. Either use a nominal WACC and Nominal cash flows or a real WACC and real cash flows — don’t mix and match. I’m not sure i have a better explanation as to why it’s ok to include inflation risk in the wacc and cash flows whereas it’s not ok for other risks ----- perhaps i’m wrong here, but maybe someone else can chime in.

It’s kind of like tax affecting the cash flows (after-tax) and WACC. Just being consistent.

Can anyone else add to why you don’t include certain risk factors in both the WACC and cash flows???