Valuation, 7th Edition

15Estimating the Cost of Capital

To value a company using enterprise discounted cash flow (DCF), discount your forecast of free cash flow (FCF) at the weighted average cost of capital (WACC). The WACC represents the returns that all investors in a company—equity and debt—expect to earn for investing their funds in one particular business instead of others with similar risk. The investment return they are forgoing is also referred to as their opportunity cost of capital. Since a company’s investors will earn the cost of capital if the company meets expectations, the cost of capital is used interchangeably with expected return.

The WACC has three primary components: the cost of equity, the after-tax cost of debt, and the company’s target capital structure. Estimating WACC with precision is difficult because there is no way to directly measure an investor’s opportunity cost of capital, especially the cost of equity. Furthermore, many of the traditional approaches that worked for years have been complicated by recent monetary policies that have led to unusually low interest rates on government bonds. To estimate the cost of capital, we employ various models and approximations that are grounded in corporate-finance theory and build on empirical observations about the market value of companies. These models estimate the expected return on alternative investments with similar risk.

This chapter begins with a brief summary of the WACC calculation and then presents detailed sections ...