FNCE30011 · Essentials Of Corporate Valuation
Enterprise DCF: the Standard WACC
The Standard WACC values the whole firm first — discount unlevered free cash flow at ks to an enterprise value — then reaches equity by subtracting net debt (E0 = V0 − D0). It is the right tool when leverage is held to a constant target ratio (Dt = L·Vt, rebalanced each period), the Miles–Ezzell world in which the interest tax shields are as risky as the operations (kits = ku) and so the rate stays constant. The blend is ks = (1−L)ke + Lkd(1−T): each switch carries meaning — (1−L) and L weight the equity and debt costs, kd(1−T) puts the interest tax shield in the rate, and L = D/V is the course convention. The same value can be reached by the APV identity V0 = U0 + I0 — the unlevered firm valued at ku plus the present value of the financing side-effect — and a clean answer cross-checks the two routes to the same V0. As leverage rises, ks falls (more cheap, shielded debt) while ke rises (equity bears more risk); recognising which the question is asking for is itself examinable.
What this chapter covers
- 013.1 Value the firm first, equity by subtraction (E0 = V0 − D0)
- 023.2 The blend ks = (1−L)ke + Lkd(1−T) and what each switch means
- 033.3 The constant-target-ratio condition (Miles–Ezzell) and why it makes ks constant
- 043.4 The APV split V0 = U0 + I0 and the unlevered cost of equity ku
- 053.5 How leverage maps onto the rates: ks falls, ke rises with L
- 063.6 Worked: value by Standard WACC, then cross-check by APV to the same V0
Worked example: enterprise value by the Standard WACC
- +1Identify. Constant target leverage ratio → Standard WACC: discount FCFU at ks, value the firm, subtract net debt.
- +1WACC. ks = (1−L)ke + Lkd(1−T) = 0.6(0.12) + 0.4(0.06)(0.70) = 0.072 + 0.0168 = 8.88%.
- +1Enterprise value (perpetuity): EV = 120 / 0.0888 = $1,351m.
- +1Bridge. Equity = 1,351 − 300 = $1,051m; per share = 1,051 / 100 = $10.51.
- +1Check. A constant ratio (not a fixed dollar schedule) confirms the Standard WACC, and FCFU pairs with ks — the interest tax shield lives in the rate, not the cash flow.
Key terms
- Standard WACC (ks)
- The blend (1−L)ke + Lkd(1−T) used to discount unlevered FCF when leverage is a constant target ratio. The (1−T) factor puts the interest tax shield in the rate.
- Constant target leverage
- Dt = L·Vt, rebalanced each period (Miles–Ezzell). It keeps L — and therefore ks — constant, and makes the tax shields as risky as the operations (kits = ku).
- APV identity
- V0 = U0 + I0: value the unlevered firm at ku, then add the present value of the financing side-effect (the interest tax shields). A clean cross-check on the WACC route — both must reach the same V0.
- Unlevered cost of equity (ku)
- The cost of capital of the firm's operations with no debt — the rate for unlevered FCF in the APV's U0 term, and the anchor the WACC family is built around.
- Enterprise-then-equity
- The standard-WACC route's structure: value the whole firm (operations) first, then subtract net debt to reach equity — as opposed to the FCFE route, which lands on equity directly.
Enterprise DCF: the Standard WACC FAQ
Why does the standard WACC use (1−T) on the debt term?
Because interest is tax-deductible, each dollar of interest saves T in tax — the interest tax shield. The standard WACC captures that benefit by lowering the after-tax cost of debt to kd(1−T), i.e. it puts the shield in the discount rate. The cash flow being discounted (unlevered FCF) deliberately excludes the shield, so the rate carries it instead; that is what makes the (cash-flow, rate) pair consistent.
When is the Standard WACC the right model, and not the Vanilla?
Use the Standard WACC when leverage is a constant target ratio (debt rebalanced to a fixed percentage of value each period). Use the Vanilla WACC when debt follows a fixed dollar schedule, so the ratio drifts. The cue is in the question's leverage story; reading 'L = 40% maintained' points to Standard, while 'repay $50m a year on schedule' points to Vanilla.
What does the APV split add over just computing the WACC?
APV separates value into operations (U0, valued at ku) and the financing side-effect (I0, the PV of the tax shields). It is a clean cross-check — the two routes must agree on V0 — and it is the natural model when the financing benefit is lumpy or the leverage path is unusual. In the constant-ratio world the WACC is quicker; the exam values being able to move between them.
Why does ke rise while ks falls as leverage increases?
More debt loads more of the firm's business risk onto the remaining equity, so equity holders demand a higher ke. But debt is cheaper and tax-shielded, so the overall blend ks falls as the weight shifts toward kd(1−T). Knowing which way each moves — and that they move in opposite directions — settles a common conceptual question.
Exam move
Lead every enterprise-DCF answer by naming the model: a constant target ratio is the Standard WACC. Write ks = (1−L)ke + Lkd(1−T) with L = D/V (the course convention, not D/E), value the firm as a perpetuity or finite stream of unlevered FCF, then subtract net debt and divide by shares. Keep the APV identity V0 = U0 + I0 on your A4 as a cross-check — being able to reach the same V0 two ways is a recurring exam ask. And rehearse the directional facts (ks falls, ke rises with L) so a short-answer on the effect of leverage costs you nothing.
