Free Cash Flows to Equity- Help
Hi all:
Quick question about valuing free cash flows to equity: what discount rate do you use?
more specifically, is the Y Equity equal to the cost of equity you derive from the CAPM, or do you use a different discount rate say, i don't know, derived from some formula similar to the one you use when re-levering a beta?
also, once you properly "present value" the free cash flows to equity, should the PV FCFE+ Debt = the PV you get when you discount the unlevered cash flows (free cash flows to firm) using WACC? could someone please explain why?
thanks
Ok... so there's generally three ways to discount cash flows to value a company:
Levered cash flows - discount with cost of equity (levered) = EQUITY value. Add debt = Enterprise value (your prof will usually call this V(L))
Unlevered cash flows - discount with WACC (i.e. a blended rate) = ENTERPRISE value = Equity + Debt
Now, with Unlevered cash flows, you can also discount with the cost of equity (unlevered) = Value of UNlevered firm (i.e. V(U)). Then, add the PV of interest tax shield using APV - this is NOT the value of your debt, and you will get the value of the LEVERED firm = ENTERPRISE value = V(L)
WACC is more appropriate for constant capital structure, while APV is used with a changing capital structure (since the discount rate changes) - think LBO.
Clear?
I should probably also add that when I say unlevered cash flows =FCFF and that levered cash flows = FCFE
APV and WACC add up because they are exactly the same because V(L) = V(U) + PV of interest tax shield
All you are doing is accounting for debt differently. In WACC, you account for the debt/interest through your discount rate. With APV, it is calculated on its own.
Is the rate you use to discount the FCFE the cost of equity per CAPM or is a different rate used? In other words, is the cost of equity (levered) that you mention the same as the cost of equity per CAPM or is it different?
thanks for the response
They are both CAPM cost of equity values. The difference lies in the concept of beta and leverage.
Think about it this way. So you know financial leverage (i.e. debt) amplifies your ups and downs because its a fixed cost right? Then accordingly, so if beta = the magnitude of the correlation between your firm and the market, you have to adjust it for the effect of leverage.
For cost of equity (levered), that's equal to CAPM's cost of equity when you use a LEVERED beta. Unlevered cost of equity is simply the cost of equity if a firm was 100% equity financed. That's why for the cost of equity (unlevered), you use the the asset beta (aka the UNlevered beta) with CAPM (it's also why APV works since you are just adding the firm's value if it was 100% equity financed plus the value of the interest tax shield provided by the debt).
So in FCFE, you would use the levered cost of equity from CAPM to discount it to arrive at the value of your equity.
Does that clear things up?
First off, thanks for your help,
What you say makes sense in theory (using levered beta in CAPM to get Y Equity when valuing only FCFE and using un-levered beta in CAPM to get Y Equity when valuing FCFF)
However, i was under the (perhaps faulty) impression that you use the levered beta to calculate the WACC cost of equity when valuing FCFF as well.
here are the steps i thought you would take for calculating the Y Equity used in deriving the WACC for discounting a firm's FCFF. 1) find the betas of a set of the firm's industry peers 2) un-lever these betas, take their average 3) re-lever this average beta using the firm's specific debt/equity ratio 4) use this re-levered beta in the CAPM to derive Y Equity
is the above wrong?
should i not re-lever the beta and just use the average un-levered beta when I calculate Y Equity for the WACC?
and should i only re-lever the beta when I am calculating Y Equity for discounting the FCFE?
sorry for bumping my own thread, i just really need a definitive answer to my last question
thanks for any help you can give
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