Company valuation
The discount rate has a strong influence on DCF enterprise value. This article explains WACC, its components and the effect of small changes.
Definition
WACC, the weighted average cost of capital, is the return a company must earn to compensate both equity and debt providers appropriately. In a DCF it is the discount rate used to bring future cash flows back to today.
The formula
Cost of equity is often estimated with CAPM from the risk-free rate, market risk premium and beta. Cost of debt comes from the actual borrowing rate, reduced by the tax effect because interest is deductible.
Effect on value
WACC sits in the denominator of the discounting formula and is compounded across years. A one-percentage-point change can therefore materially shift enterprise value, especially over a long forecast or when terminal value is a large part of the result. Use several WACC cases in a sensitivity analysis.
The worked DCF example shows how WACC enters a complete forecast and terminal-value calculation.
Cost of equity
Cost of equity is not a contract rate. Shareholders expect a return for bearing business risk. CAPM combines the risk-free rate, market risk premium and company beta:
The estimate may be useful for a stable, comparable company. It becomes less reliable for a young business, a changing segment or a company without good peers. Do not present rE as an objectively measured fact.
Worked example
Assume equity is 80% of financing, debt 20%, cost of equity 10%, cost of debt 5% and a model tax rate of 30%.
The resulting 8.7% discounts free cash flows in the DCF. If capital structure or required equity return changes, WACC changes too. It cannot be chosen independently of the business and its financing.
Use in a DCF
If you value free cash flow to the firm, use a discount rate that includes equity and debt. If you value cash flow to equity, use a matching cost of equity. Cash flow and discount rate must describe the same level.
The enterprise version first produces enterprise value. Subtract interest-bearing debt and add excess cash to reach equity value; then account for shares, options and dilution. A lower WACC makes present value higher, but that is a different risk assumption, not a free improvement in the business.
Error sources
Always show sensitivity. Do not report only 8.7%; show what happens at a higher and lower rate. That reveals whether the valuation rests on the business or almost entirely on WACC.
Comparability
A software company with recurring revenue, a cyclical manufacturer and a highly leveraged property company do not carry the same risk. Even with the same market interest rate, their cost of equity and suitable capital structure can differ materially.
When using peers, review differences in beta and leverage. A company with more debt can show a different beta even when operations are similar, so peer data may need to be adjusted. You do not need every academic refinement in a personal model, but document why WACC fits the business, country, leverage and cash flow used.
Enter cost of equity and debt, then calculate WACC directly in the Excel model.
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