Question

When using a Discounted Cash Flow model, what specific impact does an increase in the Weighted Average Cost of Capital have on the calculated intrinsic value of a company?

Accepted Answer

An increase in the Weighted Average Cost of Capital, or WACC, causes the calculated intrinsic value of a company to decrease. The WACC represents the average rate of return a company is expected to pay to all its security holders, including both debt and equity investors, to finance its assets. In a Discounted Cash Flow model, the intrinsic value is determined by taking the future free cash flows a company is expected to generate and discounting them back to their present value. Discounting is the mathematical process of adjusting future money to account for the time value of money, which is the concept that a dollar today is worth more than a dollar tomorrow due to its potential earning capacity. The WACC serves as the discount rate in this calculation. Because the discount rate sits in the denominator of the present value formula, a higher WACC means that each unit of future cash flow is divided by a larger number. For example, if a company is expected to generate 100 dollars in one year, discounting that at a 10 percent WACC results in a present value of approximately 90.91 dollars. If the WACC increases to 15 percent, the present value drops to approximately 86.96 dollars. Therefore, because the WACC reflects the risk or the required return associated with those cash flows, a higher cost of capital mathematically reduces the present worth of those future earnings, leading directly to a lower total intrinsic value for the business.

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When using a Discounted Cash Flow model, what specific impact does an increase in the Weighted Average Cost of Capital have on the calculated intrinsic value of a company?