Question

You have been assigned the task of using the corporate, or free cash flow model to estimate KCB Corporation's intrinsic value. The firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is expected to be $75.0 million, the FCFs are expected to grow at a constant rate of 5.00% a year in the future, the company has $200 million of long-term debt and preferred stock, and it has 30 million shares of common stock outstanding.

Why should the WACC be used as the discount rate in calculating the total firm value? Explain.

Answer 1

Answer-

Given

WACC = 10 %
Free cash flow( FCF1) = $ 75.0 million
Expected growth rate of FCFs = g = 5 %
Debt and preferred stock = $ 200 million
Common shares outstanding = 30 million

The WACC is is used as the discounting factor in calculating the firm value (FCFF) as we are inluding both debt and equity into account and as we know that the total firm value is equal to market value of equity and market valueof firm.
The FCFF takes into account all the cash flows available to investors including bond holders and shareholders after the firm buys and sells products, provides services, pays its operating expenses and makes its short and long term investments.
The FCF to equity (FCFE ) is discounted at the required return on equity whereas the FCFF uses WACC as discountig factor.

When the company is having negative FCFE ans significant amount of debt then FCFF is the best choice.

Intrinsic value of Firm (V0) = FCF1 / (WACC - g)

V0 = $ 75.0 m / ( 10 % - 5 %) = $ 75.0 m / (0.10 - 0.05)

V0 = $ 75.0 m / 0.05 = $ 1500 million