If we are discounting UFCF in a DCF analysis, why don't we account for the cost of capital for NCI in the WACC we discount the cash flows by? (Though I'm not sure how this can be estimated.) My understanding is that UFCF is available to non-controlling interests of the firm since UFCF is calculated from EBIT (which consolidates the parent and the subsidiary's income).
Would greatly appreciate the clarification guys!
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You account for NCI in the Equity bridge by substracting them from the EV to get to the EqV (most quick and dirty DCF models simply take the balance sheet value, but theoretically you should substract the market value of NCIs). So the reason why you don't account for NCI in the WACC is that you compute your entire Enterprise Value which is the economic value of all operating assets consolidated (thus including the NCIs). WACC is derived from a cost of debt and a single cost of equity which is equal for all equity holders: this implicitly assumes there is no difference in the cost of equity required by holders of the company's NCIs and holders of the company's group share equity. However, if your company had issued preferred shares, it would make sense to adjust the WACC by using a different required rate of return on those as it is another type of financial asset.
Ok I understand that you subtract NCI from EV to arrive at Equity Value since the EV calculated includes the value of NCI. But I still don't understand why you don't factor the cost of equity required by the firm's NCIs into WACC to arrive at that EV?
If the NCI is large enough, you will need to adjust your WACC calculation to include NCI as a source of equity capital. If you don't do this, your WACC will be too low. People don't usually bother making this adjustment because NCI is usually not large enough to have a meaningful impact on WACC.
Right okay! Just curious, any idea how people estimate the cost of equity for NCI in practice? Technically, should we also account for the cost of debt for NCI since EBIT of parent company is also available to debt holders of the subsidiary?
It's usually pretty safe to use the same cost of equity as the parent, unless the NCI is significant and the profile of the sub is very different from the parent. In that case, you should consider valuing the sub separately on its own and deriving a cost of equity that is appropriate for that sub. For the debt, the answer is yes. However, in general, these cost adjustments will not impact your WACC meaningfully. The only adjustment that you should probably focus on is making sure you include NCI in the cap structure when calculating WACC especially if it is meaningful source of capital to the firm, given that your UFCF include 100% of the cashflows from the sub.
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