A capital-structure-neutral cash flow needs a capital-structure-neutral discount rate
The Finance Storyteller · WACC Explained
The idea
Unlevered free cash flow belongs to everyone who funds the business, before any of them are paid. Discounting it at the cost of equity alone would ignore the lenders; discounting at the cost of debt would ignore the owners. The weighted average cost of capital blends the two in proportion to how the business is funded, with the cost of equity built from the risk-free rate, a beta and an equity risk premium, and the cost of debt taken after tax because interest is deductible. The Finance Storyteller builds the formula and then the cost of equity inside it, which is the order to learn it in.
Match the discount rate to the cash flow: a flow to all capital providers is discounted at the blended cost of all of them.
When it works
The discount-rate questions in a DCF interview, and any model where the cash flow and the rate have been matched carelessly.
When it may fail
Every input is an estimate and some, the equity risk premium above all, are argued over. The formula is settled; the numbers that go into it are not.
How to use it
Run the WACC lab with a real company's inputs and say what each input is doing: why the cost of debt is after tax, why beta is levered, and what happens to the rate if the company borrows more.
Where it came from
Video WACC Explained · The Finance Storyteller
What the source says. The Finance Storyteller builds the WACC formula, then the cost of equity and the capital asset pricing model inside it.
Connected ideas
Worth knowing first
A DCF is machinery for one sentence: value is the present value of expected cash flowsEvery cell in a DCF is a claim about future cash or about its risk; if you cannot say which, the cell should not be there.
Says something similar
Terminal value is usually most of the answer, and most of the riskCheck what share of the value is terminal and what multiple the terminal assumptions imply; those two checks catch most broken DCFs.
Takes it further
How much debt is the right amount: the cost-of-capital approachThe right amount of debt minimises the blended cost of capital; the maximum a lender will provide is a different and larger number.
Concepts
Put it to work on L3VLUP
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