Is there a "Right" Discount Rate for Calculating Value? [View article]

I have a question about the WACC:

Some people use the WACC as the discount factor, when assessing the value of a firm with the DFC (discounting free cash flow) method.

In my opinion, this can lead to a distorted discount factor that is too small, for the risk you take on your investment.

When the cost of capital of debt (for example 5%) is less than the cost of capital of equity (for example 12%), then, with more debt on the balance sheet, the discount factor becomes less, while the risk of the leveraged company becomes higher.

For example: IBM's WACC Long-term debt as percentage of capital: 35% Tax rate: 29% Cost of equity CAPM estimate: 12.7% Yield on IBM long bond: 5.6%

So the WACC = 0.35(5.6%)(1-0.29)+0.6...

When the percentage of debt on the balance sheet chances to, lets say, 55%, the WACC will be:

WACC = 0.55(5.6%)(1-0.29)+0.4...

So again, high debt on the balance sheet in this model, means low discount factor, while anybody who is perceiving this firm to be a higher risk on your investment due to leverage, will, of course, use a higher discount factor.

Can anybody explain to me, why I am wrong in my perception that using the WACC (as prescibed by the CFA) as a discount factor in the DFC model, this eventually leads to false interpretation of risk!

Some people use the WACC as the discount factor, when assessing the value of a firm with the DFC (discounting free cash flow) method.

In my opinion, this can lead to a distorted discount factor that is too small, for the risk you take on your investment.

When the cost of capital of debt (for example 5%) is less than the cost of capital of equity (for example 12%), then, with more debt on the balance sheet, the discount factor becomes less, while the risk of the leveraged company becomes higher.

For example: IBM's WACC Long-term debt as percentage of capital: 35% Tax rate: 29% Cost of equity CAPM estimate: 12.7% Yield on IBM long bond: 5.6%

So the WACC = 0.35(5.6%)(1-0.29)+0.6...

When the percentage of debt on the balance sheet chances to, lets say, 55%, the WACC will be:

WACC = 0.55(5.6%)(1-0.29)+0.4...

So again, high debt on the balance sheet in this model, means low discount factor, while anybody who is perceiving this firm to be a higher risk on your investment due to leverage, will, of course, use a higher discount factor.

Can anybody explain to me, why I am wrong in my perception that using the WACC (as prescibed by the CFA) as a discount factor in the DFC model, this eventually leads to false interpretation of risk???

Kimberly-Clark: fairly valued with a margin of safety [View instapost]

Dear Eric,

I have a question for you. All the cash flows you describe in your article are paid to the shareholders of the common stock of the company, as Kimberley Clark has no preferred stock or other minority interests. Why should you abstract the outstanding debt from the total amount of free cash flow, as the interest to these debt holders are already paid from other sources? It is, in other words not the present value of the entire firm, but it is (without abstracting the debt) the present value for the equity holder. Could you comment on this.

McDonald's: Fairly Valued With Little or No Margin of Safety [View article]

Dear Eric,

I have made my own valuation on McDonalds, and I came to the same conclusions. The revenue and net income growth rate of McDonalds was 8 and 9 percent in the last thirty years, so I don't think this will get any better for the period to come. I do believe you should not use the WACC percentage of the company to find out if MCD will treat you well, you should use a 15% discount rate, the number you want for the return on your investment. If you use a 6 percent discount rate, that is what you get at the end of the year (minus broker commission, inflation, and taxes).

## Is there a "Right" Discount Rate for Calculating Value? [View article]

Some people use the WACC as the discount factor, when assessing the value of a firm with the DFC (discounting free cash flow) method.

In my opinion, this can lead to a distorted discount factor that is too small, for the risk you take on your investment.

When the cost of capital of debt (for example 5%) is less than the cost of capital of equity (for example 12%), then, with more debt on the balance sheet, the discount factor becomes less, while the risk of the leveraged company becomes higher.

For example: IBM's WACC

Long-term debt as percentage of capital: 35%

Tax rate: 29%

Cost of equity CAPM estimate: 12.7%

Yield on IBM long bond: 5.6%

So the WACC = 0.35(5.6%)(1-0.29)+0.6...

When the percentage of debt on the balance sheet chances to, lets say, 55%, the WACC will be:

WACC = 0.55(5.6%)(1-0.29)+0.4...

So again, high debt on the balance sheet in this model, means low discount factor, while anybody who is perceiving this firm to be a higher risk on your investment due to leverage, will, of course, use a higher discount factor.

Can anybody explain to me, why I am wrong in my perception that using the WACC (as prescibed by the CFA) as a discount factor in the DFC model, this eventually leads to false interpretation of risk!

## ROIC vs. WACC [View instapost]

Some people use the WACC as the discount factor, when assessing the value of a firm with the DFC (discounting free cash flow) method.

In my opinion, this can lead to a distorted discount factor that is too small, for the risk you take on your investment.

When the cost of capital of debt (for example 5%) is less than the cost of capital of equity (for example 12%), then, with more debt on the balance sheet, the discount factor becomes less, while the risk of the leveraged company becomes higher.

For example: IBM's WACC

Long-term debt as percentage of capital: 35%

Tax rate: 29%

Cost of equity CAPM estimate: 12.7%

Yield on IBM long bond: 5.6%

So the WACC = 0.35(5.6%)(1-0.29)+0.6...

When the percentage of debt on the balance sheet chances to, lets say, 55%, the WACC will be:

WACC = 0.55(5.6%)(1-0.29)+0.4...

So again, high debt on the balance sheet in this model, means low discount factor, while anybody who is perceiving this firm to be a higher risk on your investment due to leverage, will, of course, use a higher discount factor.

Can anybody explain to me, why I am wrong in my perception that using the WACC (as prescibed by the CFA) as a discount factor in the DFC model, this eventually leads to false interpretation of risk???

## Kimberly-Clark: fairly valued with a margin of safety [View instapost]

I have a question for you. All the cash flows you describe in your article are paid to the shareholders of the common stock of the company, as Kimberley Clark has no preferred stock or other minority interests. Why should you abstract the outstanding debt from the total amount of free cash flow, as the interest to these debt holders are already paid from other sources? It is, in other words not the present value of the entire firm, but it is (without abstracting the debt) the present value for the equity holder. Could you comment on this.

## McDonald's: Fairly Valued With Little or No Margin of Safety [View article]

I have made my own valuation on McDonalds, and I came to the same conclusions. The revenue and net income growth rate of McDonalds was 8 and 9 percent in the last thirty years, so I don't think this will get any better for the period to come. I do believe you should not use the WACC percentage of the company to find out if MCD will treat you well, you should use a 15% discount rate, the number you want for the return on your investment. If you use a 6 percent discount rate, that is what you get at the end of the year (minus broker commission, inflation, and taxes).

Greetings Mark