WACC and Risk Free Rate Yield Curve
Hello,
In all the DCF models it seems we are using a constant WACC regardless of valueing cash flows in year 1 or year 15. Obviously WACC is driven by the risk-free rate on the cost of debt and the CAPM. So even if we assume certain inputs constant (beta, market risk premium etc), should a DCF model not have a dynamic WACC which is aligned with the yield curve for the individual cash flows?
Have you seen applications of dynamic WACCs for DCFs to account for the yield curve? (note: I do not mean dynamic WACC's for changes in capital structures for LBOs, just for changes in risk free rate).
Thank you for sharing your perspective.
Issma
for what purposes are you running the DCF?
I am actually not running a DCF in a traditional sense. It is more a conceptual question of how a business should value $1 in 1 year versus $1 in 10 years. Clearly in such a simple scenario a 10 year WACC proxy is not applicable as some sort of average timing.
the RFR should correspond to the projected holding period of the asset, since this input indicates the return you receive for supposedly zero risk. NPV is the value of tomorrow's cash flows in today's dollars assuming the investment were made today (or as of a certain day). So to me, a RFR should not be dynamic, but represent the available riskless return, as of a certain date, corresponding with the expected holding period of the asset.
I think it theoretically should - I always thought most people use the 10 year as an approximation.
This.
If the OP can predict interest rates as they change throughout a forecast model, why is he running his own forecast models? He should be sitting on his private island sipping fruity umbrella drinks...
Not sure what your answer has to do with anything.
No - hopefully I am answering the question that you are trying to answer. The key here is that the risk you are evaluating for a new project or acquisition or whatever is relative to the risk free rate at that time. In other words, if I have $1m today, after accounting for various factors of risk like beta, market risk, size risk, geopolitical risk and so on, would I be better off putting that cash into the investment being evaluated, or holding onto it to clear my desired return.
Another way to think about it can be related to commodities. As oil and NG price dropped, many people said deals could not be made because the bid/ask was too wide. What was really happening was that using the forward curve as it was did not get to very attractive valuations for sellers. Sellers said, well you cannot value the asset because the prices will not be this low for so long, or that the market is wrong. If both the buyer and seller agree that the market is wrong, then isn't the better investment then to bet that the market is wrong and take a position in futures, rather than the asset itself?
The same can be said for the 10-yr note or whatever you want to use as a benchmark for your WACC. You need to evaluate the investment based on current market conditions, and if you have a view on the market that affects the value of the assets, then why not just bet on the market.
I don't think he's asking about projecting interest rate changes over the projection period. I think he's asking why we don't use the 1-year risk free rate for 1st years cash flows, 2-yr for second year, etc. which I believe is more theoretically correct. It just seems really tedious, and based on how the pvs work out using the 10 year seems to average out the appropriate rates well for before and after 10 yrs.
Hadn't though of it this way. I like it.
OP - one thing to take into account is that if the company has floating rate debt and you build a proper model that takes into account projected rates, then you'll already see less cash flow because of rising interest expense. That way, you incorporate impact of rates on business, but your analysis uses the proper WACC (as outlined by George_Banker
Think of WACC more broadly as opportunity cost. In that sense, your opportunity cost is about what exists today and not what the cost will be in the future.
This actually is the right way to think about it. Conceptually, the yield curve represents a collection of different time horizon spot rates. However, it is practically hard to implement every single spot rate with its respective cash flow. That's why a YTM is used.....it is essentially an average of the spot rates between two time periods. They are mathematically equivalent
WACC and Risk Free Rate (Originally Posted: 10/09/2017)
If 10-year Treasury bond yields are abnormally low (say 2%) compared to the historical norms (say 4%), which Risk-Free Rate should I use when finding WACC?
This is more of a theoretical question...don't get caught up with current bond yields.
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