A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation

5 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Abstract

This technical note compares two methods of treating debt usage in discounted-cash-flow valuation of investment projects or companies. The note demonstrates that the approach using weighted-average cost of capital (WACC) and the approach using equity residual (ER) yield equivalent results if consistent assumptions are used. General features are illustrated with specific examples, including a spreadsheet.

Excerpt

UVA-F-1301

Rev. Jan. 25, 2017

A Comparison of the Weighted-Average Cost of Capital

and Equity-Residual Approaches to Valuation

Methods for valuing capital-investment decisions or firms include two alternative approaches for examining streams of cash flow and their related discount rates. The first and most widely used for project-oriented capital investments discounts the after-tax free cash flows by the weighted-average cost of debt and equity (capital) to determine if the result will yield a positive net present value. The main alternative technique, often used in real estate or other instances where financing is easily or directly related to the investment decision, is known as the equity residual (ER) value approach. The method gets its name because the cash flows discounted in this procedure are the after-tax free cash flows minus debt-service flows; thus, the method values the remaining cash flows to equity, discounted by the cost of equity. The key differences in the two methods are the treatment of financial leverage and the effects of such debt use on value.

The first approach, referred to as the weighted-average cost of capital (WACC) method, results in the valuation of the entire asset base inherent in the project the “enterprise” value. From this asset value, one must subtract the value of debt to get an estimate of the remaining value to equity. In essence, the WACC approach focuses on operating considerations. Financing concerns are handled via the discount rate.

. . .

Keywords: valuation, discounted cash flow, WACC, weighted average cost of capital

Suggested Citation

Harris, Robert S., A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation. Darden Case No. UVA-F-1301, Available at SSRN: https://ssrn.com/abstract=909683

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

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