Which is more sensitive in a DCF: FCF or the Discount Rate?
Looking at the impact of increasing taxes on valuation.
On one hand, (assuming debt is in the capital structure) the cost of debt decreases due to the larger impact of the tax shield. This reduces the associated risk of debt thus reducing the risk profile of the company, reducing the cost of that companies equity. This is also demonstrated in the formula for Levered Beta: BL = BU*(1+(1-T)(Debt%/Equity%)). So we have cost of debt and cost of equity falling with higher taxes, so a lower WACC.
However, Unlevered FCF = NOPAT + Non Cash Adjustments - Capex - Changes in Net Working Capital. Higher taxes will reduce NOPAT, which will thus reduce Unlevered FCF.
What will impact the DCF valuation more: lower FCF or lower WACC?
EDIT: Figured it out, was ridiculously simple. WACC has a greater impact because it is discounted for every forecast future period. So it's squared in year 2, cubed in year 3 etc.
WACC is more important for sure. It's also harder to estimate it, and small changes will change your decision. For example if you are calculating your returns with arithmetic or geometric average, which is only part of WACC will already make big difference by at least 1% of WACC in normal market conditions.
Sorry, are you able to clarify your answer for me at all? How do returns feature in the WACC equation?
Part of the WACC equation is cost of equity which is normally estimated using CAPM. I'm sure you can connect the dots beyond that.
Increase of taxes = more cash goes to government = less cash to service debt and shareholders. All else being equal your NPV will be lower.
Increasing taxes lowers both WACC and FCF. The question is which has a bigger impact on valuation in an unlevered DCF.
Would you pay more or less to purchase the asset if you found out that taxes have increased?
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