By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)

## Walkthrough

### WACC

The **WACC**, or Weighted Average Cost of Capital, is the **discount factor** you use in your DCF valuation to account for the *Time Value of Money* and discount the Free Cash Flows back to their present value. The formula is:

**E/D+E **and **D/D+E** are respectively the *portions of equity and debt*, **Re** and **Rd** are the *costs of equity and debt* and **(1-t)** is the *tax shield* provided by the debt (t: corporate tax rate).

To calculate the cost of equity (Re), see after.

For other components of the formula, you usually look at *comparable companies* and the interest rates and yields issued by similar companies to get estimates.

### Cost of Equity

The **Cost of Equity** is a measure of how much return an equity investor *would expect in return* of his/her investment in the company.

Hence, you should expect a company with a *smaller market capitalization* to have a bigger Cost of Equity. Indeed, a $100mn market cap company is *expected to outperform* the market and therefore be *riskier* than a $1bn market cap company.

To calculate the Cost of Equity, you can use the **CAPM** (Capital Asset Pricing Model):

### CAPM

**Rf:** The **risk-free rate** represents how much a 10-year or 20-year Government Treasury Bill should yield.

**Beta** is a measure of *systematic risk*. It gauges the tendency of the return of a security to move *in parallel* with the return of the stock market as a whole. In other words, it is a *measure of sensitivity* of security's volatility relative to the market's volatility. A **beta of 1** indicates that the security's price tends to *move with* the market, a **beta of 0**means that regardless of any market movement, the value of the security remains *unchanged*. A **beta of -1.0** means that the stock is *inversely* correlated to the market.

Finally, the **Equity Risk Premium** is the percentage by which stocks are expected to out-perform “*risk-less*” assets hence why you compute the difference between the *Expected Return of the Market* (**E(Rm)**) and the *Risk-Free Rate*(**Rf**).

### Unlevered VS Levered FCF

**Levered** FCF is the amount of cash left after paying for *financial costs* such as interest costs and operating expenses whereas **Unlevered** FCF *doesn’t take the cost of capital into account*. In other words, the key difference between both is **expenses**.

Another way to see it: considering leverage is another name for debt, **Levered** FCF is the cash flow that only *belongs to equity holders* while **Unlevered **FCF *belongs to both the equity and the debt holders*.

Considering this explanation and the definition of WACC which takes the *entire capital structure into account,* you will have to use **Unlevered** FCFs for your **DCF** analysis. Reversely, if you use the **Levered** FCF, then you will have to use your **Cost of Equity** as the *discount factor*.

## Comments