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may be i am just overthinking on this. But i wanted to clear it out anyway. Sir as per our shared understanding WACC takes into account our interest payments, but then when we deduct MV of debt(which is our PV of future interest payments and capital repayment)from FCF to firm to arrive at FCFE, we end up deducting interest twice! that seems very strange to me. Could you help me understanding it?
Sincere Regards as always!
Maybe this little example will convince you:
Suppose the operating profit is 100 per year; the interest on debt is 10 per year and the tax rate is 20%. So the free cash flow to equity is 72 per year.
Suppose shareholders required rate of return is 10% and the debt lenders required rate of return is 5%.
The MV of equity = 72/0.1 = 720.
The MV of debt = 10/0.05 = 200.
So the total MV is 920.The cost of equity is 10% and the cost of debt = 5% x 0.8 = 4%
Therefore the WACC = 8.70%The free cash flow to the firm is 100 x 0.8 = 80.
Therefore the MV of the firm is 80/8.7% = 920. (any slight difference is simply due to rounding).
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