When would you use the Cost of Equity in a DCF?
Answer
The obvious answer is if there is no debt. But, that’s not totally correct since the WACC would just equal the CoE. The real answer is that you would use it for businesses in which you’re solving for Levered Free Cash Flow because you’re using Equity Value instead of Enterprise Value to value the business (think banks).
The reason you would solve for Levered FCF is if you wanted to get the strongest indication of a company’s profitability in order to determine how much cash it has to expand its business and pay returns to shareholders. This is not the type of FCF used in an acquisition because debt is typically swept in a transaction.
Why this matters to bankers
Bankers need to understand the edge cases of every valuation method. Knowing when to use CoE is the difference between having an accurate and inaccurate DCF.