Discount Factor for Equity Valuation

Your boss is doing a DCF. You use WACC as your discount factor. WACC includes the cost of debt and the cost of equity so it represents both of the companies financing costs.

I am a little confused on what you are asking in the 2nd part of your question though.

realplayer10:

Hi guys. I'm a 1st year analyst. Recently, I'm doing equity valuation for a power plant acquisition. I'm not major in Finance and get a bit confused by the method proposed by my boss.

Here is his method: He takes the forecast dividends, discounts them by WACC, sum the discounted results up to get the final equity value.

However, I remember that for valuating the Equity's value, the discounted factor should be Expected Return on Equity instead of WACC. Am I wrong?

I thought that equity and debt are both used by the project to generate cash flow. Therefore, the cash flow should be discounted by WACC regardless the source of funding. However, it seems that this is only the argument for using WACC when evaluating the project but not the equity.

So I just get confused by my boss' proposal. Is he wrong? Or do I misunderstand anything?

Thanks for your help! Any further discussion is welcomed :-)

is he subtracting debt from the present value of the discounted cash flows to get equity value? b/c that's how you do it.

or, he may be discounting the cash flows to equity using the cost of equity.

it wouldn't make sense to discount the equity cash flows using WACC since WACC is the levered (taking debt into account) discount rate. (you should only discount the cash flows to the firm or in your case, the cash flows to the property using the WACC)

finally, he may be using the APV method, whereby he would value the free cash flows to the property using the cost of unlevered equity to find the property's unlevered value and then add the present value of the interest tax shield to get the overall property value

regardless, i don't think he should be valuing equity cash flows using a levered discount rate (WACC) . that's an apples to oranges comparison.

Good point, I might have misread the question, i pulled up some compressed/recursive models but it seemed like the OP was asking something different.

Its called dividend discount model (DDM look it up)

DDM doesn't use WACC. If you're looking at unlevered cash flow in your dcf, you'll end up with enterprise value. Once you get this, you can subtract debt, minority interest, and preferred stock. Then add back cash. This will get you equity value.

From your description it follows your boss is making a mistake.

Dividends are a already after interest payments. Therefore the cost of of debt is already taken into account and therefore you should only take into account the cost of equity (whereas WACC is a mixed cost of equity and debt). Make sure you understood your boss correctly though, as this is a pretty basic mistake.