FNCE30011 · Essentials Of Corporate Valuation
The Model Selector
This is the decision spine of the subject — the chapter that decides every other one. Because the exam provides the formula sheet, marks are not lost remembering formulas; they are won by knowing which model to use. Two switches settle every DCF question. The first is leverage shape: a constant target ratio → the Standard WACC (discount FCFU at ks); a target debt schedule in dollars → the Vanilla WACC (discount FCF at kv, with kv = ku in the magic case); changing leverage or operating risk → the recursive standard WACC by backward induction. The second is the interest-tax-shield risk: whether the shields are as risky as the operations (kits = ku) or as risky as the debt (kits = kd). Around the two switches sit the four matched (cash-flow, rate) pairs — FCFU↔ks, FCF↔kv, FCFE↔ke, and the unlevered FCFU↔ku — and an exam decoder that maps each recurring past question type to its model and first three moves. The chapter closes with how to lay out your one bring-in A4 (six zones of method and decision logic, not raw formulas) and a 180-minute triage plan.
What this chapter covers
- 0111.1 Why model selection, not formula recall, wins the exam
- 0211.2 Switch one — leverage shape: ratio → Standard, schedule → Vanilla, changing → recursive
- 0311.3 Switch two — interest-tax-shield risk (kits = ku vs kd)
- 0411.4 The four matched (cash-flow, discount-rate) pairs
- 0511.5 The exam decoder: cue → model → the first three steps
- 0611.6 The bring-in A4 layout and a 180-minute triage plan
Worked example: read the cue, name the model
- +1Switch one (leverage shape). Debt is a fixed dollar schedule (not a ratio), so the leverage ratio drifts — this is the Vanilla WACC, not the Standard WACC.
- +1Switch two (ITS risk). The shields are as risky as the assets (kits = ku), so the magic case applies: kv = ku, a leverage-proof rate.
- +1Matched pair. The Vanilla WACC discounts FCF (interest tax shield inside the cash flow), so use FCF ↔ kv = ku.
- +1First three moves. (1) forecast FCF including the shield; (2) discount each year's FCF at kv = ku; (3) add the terminal value and run the EV→equity bridge.
Key terms
- The model selector
- The master decision tree that picks the valuation model before the formula sheet is touched, driven by two switches: leverage shape and interest-tax-shield risk.
- Switch one: leverage shape
- Constant target ratio → Standard WACC; fixed dollar debt schedule → Vanilla WACC; changing leverage or operating risk → recursive standard WACC. The first question to ask of any DCF stem.
- Switch two: ITS risk
- Whether the interest tax shields are as risky as the operations (kits = ku, giving kv = ku) or as risky as the debt (kits = kd). Sets how the shield is valued.
- The four matched pairs
- FCFU↔ks, FCF↔kv, FCFE↔ke, FCFU↔ku — the consistent (cash-flow, rate) combinations. Crossing them is the most expensive error in the subject.
- The exam decoder
- A grid mapping each recurring past-exam question type to its cue, its model, and the first three steps of the answer — the bridge from recognising a question to starting it correctly.
The Model Selector FAQ
What is the single most important habit the selector teaches?
Name the model before you compute. Every DCF stem is decided by two switches — the leverage shape (ratio, schedule or changing) and the interest-tax-shield risk — and getting those right determines whether you reach for ks, kv, ke or ku and which cash flow they pair with. Students who jump to a formula off the provided sheet without naming the model lose marks even though the formula was free. The selector makes that naming step automatic.
How do the two switches interact?
Switch one (leverage shape) chooses the family: Standard WACC for a constant ratio, Vanilla WACC for a dollar schedule, recursive for a changing path. Switch two (ITS risk) then refines the rate — most importantly, when the tax shields are as risky as the operations, the Vanilla WACC collapses to the leverage-proof kv = ku. Together they pin down both the model and the exact rate, after which you pick the matching cash flow and walk the bridge.
Why are the four matched pairs so central?
Because every consistent valuation pairs a cash flow with a rate that refers to the same claimholders and the same treatment of the tax shield: FCFU with ks (shield in the rate), FCF with kv (shield in the cash flow), FCFE with ke (equity only), and FCFU with ku (unlevered). Crossing them — say discounting FCFE at ku — double-counts or omits the shield and is the most expensive single error in the subject. Keeping the four pairs on your A4 prevents it.
What should go on my bring-in A4, given the formula sheet is provided?
Decision logic, not formulas. The exam prints the formulas, so spend the A4 on the model-selector decision tree, the four matched (cash-flow, rate) pairs, the EV→equity bridge checklist, and your own worked-step templates and traps — the moves you fumble under time. A wall of formulas wastes the page on things you already have. Six zones of method and a 180-minute triage plan are far more valuable in the room.
Exam move
Make this chapter your revision hub. Draw the model-selector decision tree from memory until the two switches are automatic: leverage shape (ratio → Standard, schedule → Vanilla, changing → recursive) then ITS risk (kits = ku → kv = ku). Memorise the four matched (cash-flow, rate) pairs and never cross them. Use the exam decoder to rehearse going from a cue to the model and its first three moves on every past-type. Lay your one A4 out as six zones of decision logic and step templates — not the provided formulas — and pair it with a 180-minute triage plan so you spend time where the marks are. Name the model first, every time.
