DCF With a Pre-tax Cost of Debt and Above-GDP Terminal Growth
You are valuing a listed Indian consumer company. Your DCF uses a risk-free rate of 7.2%, an equity risk premium of 6.0%, and a beta of 1.1, giving a cost of equity of 13.8%. The pre-tax cost of debt is 8.5%, the tax rate is 25%, and debt and equity are each at market value with D/E of 0.6. You compute WACC as 0.625 × 13.8% + 0.375 × 8.5% = 11.8%. Your five-year FCFF forecast deducts interest expense and ignores changes in working capital. Terminal growth is set at 8.0%, while you assume long-term inflation of 4.0% and real GDP growth of 3.0%. The terminal value is 78% of enterprise value. A colleague says the target price is 'conservative' because the stock trades at 42× earnings. Your note recommends Buy.
1. Identify the errors in the WACC and FCFF calculations and compute the corrected WACC.
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Two errors stand out.
First, the cost of debt must be after tax because interest is tax-deductible and FCFF is an unlevered cash flow. The after-tax cost of debt is 8.5% × (1 − 0.25) = 6.375%, not 8.5%.
Second, the weights should be based on market values, which the setup states are being used. With D/E = 0.6, D/(D+E) = 0.6/1.6 = 0.375 and E/(D+E) = 1.0/1.6 = 0.625. The corrected WACC is:
WACC = 0.625 × 13.8% + 0.375 × 6.375% = 8.625% + 2.391% = 11.02%, not 11.8%.
A higher WACC lowers enterprise value, so the correction is not a minor rounding issue.
Third, FCFF should not deduct interest expense. Interest is a financing flow; if it is deducted, the analyst is mixing FCFF and FCFE and double-counting the cost of debt through the WACC. The forecast should start from EBIT × (1 − tax), add depreciation, subtract capex, and subtract the increase in net working capital. Ignoring working capital is a real error for a consumer company that may be extending credit or building inventory; it overstates free cash flow.
2. Assess the terminal growth assumption and the reliance on terminal value.
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Terminal growth of 8.0% is higher than the assumed long-term nominal GDP growth of 7.0% (4.0% inflation plus 3.0% real growth). In the long run, a company cannot grow faster than the economy forever unless it is expected to capture an ever-larger share of the economy, which is not a defensible assumption for a mature consumer company. The terminal growth rate should normally be at or below long-term nominal GDP growth; a rate of 5.0–6.5% would be more defensible, depending on inflation and the company's terminal competitive position.
A terminal value at 78% of enterprise value is not automatically wrong, but it makes the valuation highly sensitive to the terminal assumptions. The analyst should show a sensitivity table for WACC and terminal growth and check the implied terminal-year reinvestment rate. If growth is 8%, the company must reinvest enough to support it; a terminal value that assumes high growth, high margins, and low reinvestment is internally inconsistent.
Comparing the output with a 42× earnings multiple is not a substitute for checking the DCF. A high market multiple may reflect low interest rates, high expected growth, or overvaluation; it does not make a DCF with inconsistent assumptions 'conservative'.
3. What should the final recommendation note say, and what valuation checks should be added?
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The recommendation should not be published as a Buy until the model is corrected. The corrected WACC and working-capital adjustment will likely reduce the target price, and the terminal growth assumption must be brought into line with long-term nominal GDP. The note should explain the changes rather than silently revising the target.
Add these checks:
- Sensitivity analysis for WACC of 10.5–12.0% and terminal growth of 5.0–7.0%.
- Implied exit multiple at the end of year five, compared with the company's own history and peers.
- Reinvestment consistency: terminal growth = reinvestment rate × return on invested capital.
- Working-capital build based on receivable days, inventory days, and payable days.
- Cross-check with a relative valuation using forward earnings and EV/EBITDA, explaining why the market multiple may differ.
If the corrected value is close to the market price, the honest conclusion may be Hold, not Buy. A recommendation should follow the valuation, not the desire to justify an existing rating.