The DCF That Cannot Be Reconciled
An analyst builds a five-year DCF for a manufacturer. Free cash flow to the firm is discounted at a WACC of 11.0%. The terminal value uses a 2.5% perpetuity growth rate. The analyst then adds a $4.0M non-operating investment account to enterprise value, subtracts $12.0M of debt, and divides by shares to get equity value per share. A reviewer notices: (a) the WACC was computed using a market-value debt weight of 45%, but the analyst's own balance sheet shows book debt of $12.0M against an estimated equity value of $60M; (b) the terminal-year FCF was grown at 2.5% but capital expenditures were held flat at the year-5 level; (c) the non-operating investment generates $0.3M of annual income that was already included in projected FCF.
1. Recompute the appropriate debt weight for WACC and explain why the analyst's 45% is suspect.
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Recompute: market value of debt ≈ $12.0M (assume book ≈ market if no other data). Market value of equity ≈ $60M. Total capital = $72M.
- Debt weight = 12/72 = 16.7%
- Equity weight = 60/72 = 83.3%
The 45% figure is inconsistent with the analyst's own equity estimate. Using 45% debt would materially lower WACC (debt is cheaper and tax-shielded), inflating value.
Why it's suspect: a 45% weight implies debt of roughly $49M against $60M equity - nearly four times the actual debt. Either the analyst used a target capital structure from an unrelated peer set or made an arithmetic error. The analyst must state whether the weight is actual or target; if target, it must be justified and applied consistently. As built, the 45% cannot be reconciled to the balance sheet and should be rejected.
2. Identify the terminal-value inconsistency and state the correction.
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Problem: growing terminal FCF at 2.5% while holding capex flat is internally inconsistent. If revenue and FCF grow, the asset base must grow too; flat capex understates reinvestment and overstates terminal FCF.
Correction: set terminal-year reinvestment so that growth is funded. A common approach: terminal reinvestment rate = g / ROIC. If g = 2.5% and sustainable ROIC = 12%, reinvestment rate ≈ 20.8% of after-tax operating income. Equivalently, grow capex and working capital in line with the growth assumption rather than freezing them.
Sanity check: terminal growth of 2.5% should not exceed long-run nominal GDP growth; if it does, revisit. Also confirm terminal-year margins are sustainable, not peak.
3. Address the double-counted non-operating income and describe the correct bridge from enterprise to equity value.
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Double count: the $0.3M of investment income is already in projected FCF, and the $4.0M asset is added to EV. That counts the asset's earnings and its principal.
Correct bridge (pick one consistent treatment):
- Option A - exclude from FCF: remove the $0.3M from projected FCF, then add the $4.0M investment at fair value to EV. Subtract debt. This is cleanest.
- Option B - include in FCF: keep the $0.3M in FCF, and do not add the $4.0M separately.
Mixing the two overstates equity value by roughly the asset value plus its capitalized earnings. The analyst should also confirm the $4.0M is at fair value, not book, and subtract any debt-like items (e.g., underfunded pension, capitalized leases) consistently. The revised bridge: EV (from corrected DCF) − debt + non-operating assets (if excluded from FCF) = equity value.