Modeling Cash Flows with Constant Leverage: A Note
8 Pages Posted: 12 Jul 2005
Date Written: June 28, 2005
It is widely known that if the leverage is constant over time, then the after-tax Weighted Average Cost of Capital (WACC) is constant over time. In other words, it is inappropriate to use a constant after-tax WACC to discount the free cash flow (FCF) if the leverage changes over time. However, it is common to find analysts who inconsistently use a constant after-tax WACC even if the leverage is not constant.
In this teaching note, we use a simple numerical example to illustrate how to model cash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values.
Keywords: WACC, constant leverage, cash flows
JEL Classification: D61, G31, H43
Suggested Citation: Suggested Citation