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CS Professional · Corporate Restructuring, Valuation and Insolvency · Valuation of Business and Assets for Corporate Restructuring

Sunrise Textiles Ltd, being acquired by Kalyani Group, is valued by the DCF method. Which discount rate is conceptually appropriate for discounting its free cash flows to firm (FCFF) to arrive at enterprise value?

FCFF is discounted at the weighted average cost of capital, because these cash flows are available to both equity holders and lenders. Cost of equity suits cash flows to equity only, so using it for FCFF would mismatch cash flows and discount rate.

  1. ACost of equity only
  2. BWeighted average cost of capitalCorrect
  3. CRisk-free rate only
  4. DCoupon rate on the latest debentures

Explanation

FCFF belongs to all capital providers (equity and debt), so it must be discounted at the weighted average cost of capital. Cost of equity is used for free cash flow to equity. Using it for FCFF would ignore the cheaper debt component and misstate enterprise value.

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