FCFF and usage of the correct discount factor for Valuation

 

I was working for a government client recently and the client wanted Valuation exercise to be done for their organisation. The valuation assignment was handed over to a third-party firm. Once they completed the valuation I was asked to review the Valuation Model. Two mistakes which I caught in the model which I felt drastically misvalued the firm:

• FCFF was discounted using Cost of Equity.

The right approach: FCFF always have to be discounted using WACC- The Weighted Average Cost of Capital. WACC considers Cost of Debt, Tax Effect on Debt, Cost of Equity and the weights of Debt and Equity.

FCFF represents Cash Flows to the entire firm, even before Debt repayment is done, hence the correct discount factor is always WACC.

• Not considering Tax effect in WACC calculation: 

2.      The model did calculate WACC in one of its sheets, but the WACC calculation did not include Tax effect. This is again incorrect, taking optimal debt always gives a Tax benefit and reduces the cost of debt, and hence WACC should consider Cost of Debt * (1- Tax Rate) in its formula; Tax effect cannot be ignored while calculating WACC.