Valuation: Measuring and Managing the Value of Companies, Fifth Edition

11

Estimating the Cost of Capital

To value a company using enterprise discounted cash flow (DCF), discount your forecast of free cash flow (FCF) by the weighted average cost of capital (WACC). The WACC represents the opportunity cost that investors face for investing their funds in one particular business instead of others with similar risk.

The most important principle underlying successful implementation of the cost of capital is consistency between the components of the WACC and free cash flow. Since free cash flow is the cash flow available to all financial investors, the company’s WACC must also include the required return for each investor. To assure consistency among these elements, the cost of capital must meet the following criteria:

• It must include the opportunity costs of all investors—debt, equity, and so on—since free cash flow is available to all investors, who expect compensation for the risks they take.

• It must weight each security’s required return by its target market-based weight, not by its historical book value.

• Any financing-related benefits or costs, such as interest tax shields, not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value.⁹⁴

• It must be computed after corporate taxes (since free cash flow is calculated in after-tax terms).

• It must be based on the same expectations of inflation as those embedded in forecasts of free cash flow.

• The duration of the ...