To all value investors, 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 DCF (discounted 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)+0.65(12.7%)=9.6%
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)+0.45(12.7%)=7.9%
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 DCF model, this will lead to false interpretation of risk!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.