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From the question you have been appointed to advise on the validity of the free cash flow to equity model as a basis for valuing both firms and the requirement ask to estimate the WACC and the current entity value for each business. My question is :
1. the valuation method used was the free cash flow instead of the Free cash flow to equity, with this point to note is the discount factor would be different (free cash flow- Wacc, Free cash flow to equity cost of equity)
2. the deduction for the share option & pension deficit was not tax.
3. Why the deduction for the share option & pension cost was not deducted from the net operating profit after tax and new reinvestment before calculating the cash flow at point zero.
4. what is the effect of debt finance on Wacc. It increase Wacc or reduce wacc.
1 Yes – if using free cash flow to equity, the the relevant discount rate would be the cost of equity. (Although, since part (a) of the question asked for the WACC and then for the entity value, you needed to look at the free cash flow. Otherwise you would only be arriving at a value for equity).
2 I do not understand what you are asking. The share option and pension deficit are certainly not tax.
3 The share option and pension deficit are not annual cash flows – they will be a one-off cost.
4 I am not sure of the relevance of this to the actual question. However increasing debt finance (and therefore increasing the gearing) should reduce the WACC (according to Modigliani and Miller) due to the tax benefit associated with debt.
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