Valuation of Cash Flows with Constant Leverage: Further Insights

Abstract

It is widely known that if the leverage is constant over time, then the cost of equity and the Weighted Average Cost of Capital (WACC) for the free cash flow, FCF, is constant over time. In other words, it is inappropriate to use a constant WACCFCF to discount the free cash flow (FCF) if the leverage changes over time and some conditions are not satisfied. However, it is common to find analysts who inconsistently use a constant WACCFCF even if the leverage is not constant and the proper conditions are not satisfied.

In this teaching note, we use a simple numerical example to illustrate how to model cash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values.

The note is based on a previous one and includes the procedure to value with constant leverage when some restrictive conditions are not satisfied.

Keywords: WACC, constant leverage, cash flows

JEL Classification: D61, G31, H43