A Defense of the Classic FCF WACC: A Rejoinder to the Retrospection

Abstract

In this rejoinder, we note that the complaint against the classic FCF WACC is misplaced because it incorrectly identifies the real source of the problem. The fault for the discrepancies, dear colleagues, lies not in the classic formulation of the FCF WACC. The real reason for the discrepancies is more technical, subtle and nuanced. In the valuation of cash flows, the discrepancies in the results from the three methods are due to the inconsistency between the specification of the discount rate for the tax shield KTS and the corresponding expression for the return to levered equity KE. The results from all the methods will always match if the analyst uses the correct expression for KE that corresponds to the value of KTS.

Cautionary note: This rejoinder draws on and summarizes ideas that were discussed in regular, polite (?) emails between the authors; however key differences remain and need to be resolved. For the moment, this rejoinder represents the best (mis)understanding and interpretations of the fundamental concepts.

Keywords: Weighted Average Cost of Capital (WACC), Free Cash Flow (FCF)

JEL Classification: D61, H43, M21, M40, M46, G12, G31, G33