In DCF, what is WACC used for?

In DCF, what is WACC used for?

• A. Discount future FCF to present value
• B. Forecast revenue growth
• C. Estimate terminal value directly
• D. Determine optimal capital structure

Answer: (A)

WACC represents the overall required return on the firm’s invested capital, blending the costs of debt and equity in proportion to their use. In a DCF, this rate is applied to forecasted free cash flows to present value because it captures the risk and opportunity cost of tying up capital in the business. Discounting the projected cash flows at WACC yields the enterprise value; from there, net debt adjusts to give equity value. The terminal value is also discounted back using the same rate, rather than being estimated directly by WACC. WACC does not forecast revenue growth, and it doesn’t itself determine the optimal capital structure—the structure affects WACC, while WACC is used to value the cash flows.

WACC represents the overall required return on the firm’s invested capital, blending the costs of debt and equity in proportion to their use. In a DCF, this rate is applied to forecasted free cash flows to present value because it captures the risk and opportunity cost of tying up capital in the business. Discounting the projected cash flows at WACC yields the enterprise value; from there, net debt adjusts to give equity value. The terminal value is also discounted back using the same rate, rather than being estimated directly by WACC. WACC does not forecast revenue growth, and it doesn’t itself determine the optimal capital structure—the structure affects WACC, while WACC is used to value the cash flows.