Rising sophomore currently doing some light studying for technicals. Reading the Rosenbaum & Pearl book and am struggling to understand the concept of how dividing future cash flows by WACC gives you the present value of those cash flows. If someone could give a beginner level explanation on this I would really appreciate it. Thanks in advance.
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You have the formula wrong, dividing by WACC does not give present value. That would be the present value of that cash flow in perpetuity.
Recall the future value formula FV = PV * (1 + r)^t. The future value is the present value multiplied by 1 + the discount rate, raised to the number of periods. Think of it like interest compounding on your principal where the discount rate is the interest rate (rate of return). The present value formula is just this rearranged, so PV = FV / (1 + r)^t.
WACC is the weighted average cost/discount rate/expected return for all of the company's sources of capital.
Thank you!
Time value of money. You discount back the future cash flows based on WACC, which essentially is the expected return rate demanded by investors when they invest in the company of the similar risk profile. This concept does apply to valuing everything with cash flow beyond DCF.
Thanks, appreciate it
Your WACC (Weighted Average Cost Of Capital), is just the required return on your investment. Think about the concept of the time value of money. Essentially money received today is worth more than money received tomorrow because you could invest that money today and get a return. When it comes to the WACC you essentially weight your cost of capital to the capital structure of the business (i.e. the mix of debt & equity). Since debt and equity are fundementally different they’ll have a different cost attached to it. You discount it at each interval because as time goes on those cash flows are worth less (Done by: Cashflows * (1 + WACC)^year of cash flow). Then you just sum those cash flows which will now be at their present value.
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