This is more of a theoretical question that I need help with. Many fundamental analysts don’t believe in WACC. They still use a FCFF approach, but discount it by, say 11-14% (saying that they are discounting the unlevered cash flows by an estimated number). When doing this, aren’t they saying that the cost of equity is rather high (for leveraged firms) because of the tax benefits of debt? Do they not believe the tax benefit should be counted? If you work backwards from the cost of debt, then the cost of equity would be extremely high! Does anyone understand the belief behind this…and could explain it to me?
do you mean the belief behind wacc? or the belief behind discounting by 11-14%? Can you cite an analyst who does the latter?
what is the belief behind not using wacc when discounting FCFF?
Well, if you google ‘wacc shortcomings’, you’ll encounter plenty of problems with it. E.g. from http://www.econ.kuleuven.be/eng/tew/academic/afi/pdfs/AFI_0707.pdf, though this talks more about project valuation. E.g. http://zonecours.hec.ca/documents/H2007-1-929970.Lecture10.ppt has a whole section “problems with wacc”. And then there’s Buffett, who said “I don’t even know what our cost of capital is!” Can you do a little research and post the top 5 problems with wacc?
Thank you for a starting point. I did a little bit of research, and I have found the following pitfalls. I came across many more, but these were some of the more relevant for pricing stocks. I plan on doing more research. Problems with using WACC as a discount for analyzing a firm: 1. Tax savings from interest are non-existent when EBIT is too low, thus WACC overestimates the tax savings. a. Personal thoughts: WACC may be sufficient for a firm with low debt and high earnings, but not for a firm with high debt and low earnings 2. WACC ignores risk of financial duress 3. WACC uses CAPM…too many problems with this to list 4. WACC may not be appropriate due to changing capital structure
That’s just four. Prof. Hacker won’t like that much as he was very clear that the assignment was to post the top 5.
80% is good enough for cfai, it’s good enough for me. (BTW lxada, #4 is addressed by APV.)
Prof Hacker, How does one pronounce Cenesizoglu??
Prof Hacker, I did a little bit of research on APV and basically step 1 is equivalent to the model I am talking about. Have you ever heard of someone discounting FCFF by a required rate of return on equity, subtract MV of debt, and add back cash? Essentially, this does not add back the tax shield you get for using debt…and does not add value to a company that uses debt. Ever heard of an analyst following this format?