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CA Final · Advanced Financial Management · Business Valuation

In a DCF valuation, which pairing of cash flow and discount rate is internally consistent?

FCFF should be discounted at WACC to obtain enterprise value, from which net debt is subtracted to reach equity value. FCFE, being the residual to shareholders, is discounted at the cost of equity. Mixing these gives inconsistent valuations.

  1. AFCFF discounted at the cost of equity
  2. BFCFE discounted at WACC
  3. CFCFF discounted at WACC to get enterprise value, then net debt deducted to get equity valueCorrect
  4. DFCFE discounted at the pre-tax cost of debt

Explanation

FCFF belongs to all capital providers, so WACC is appropriate and gives enterprise value; subtracting net debt gives equity value. FCFE is after debt flows and must be discounted at cost of equity, so B and D mismatch the rate. Option A uses an equity rate on a firm-level flow.

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