QUESTION 1 (4 marks)

"You know, it is often said that the vanilla WACC treats the interest tax shield as an increase in cash flow whereas the standard WACC treats the interest tax shield as a decrease in the discount rate. But I think this is only half the story"

What do you think?

Use this concept:

The matching principle concept tells us both the Vanilla and Standard WACC Model have a combined debt and equity cash flow and a combined debt and equity discount rate. However, it is important to consider tax effective interest (ITS) for matching purposes as there are different cash flows and discount rates.

Vanilla WACC--> The Vanilla WACC is the weighted average of k_e and k_d- also, a valuation that considers ITS in both cash flows and discount rate. The benefits of the ITS goes the equity investors while debt investors get the principal and interest.

Consequently, the ITS increases the amount of FCF and that additional cash flow goes to the equity investors. Therefore - k_e, after the company tax return, reflects the benefits of the ITS and became higher than it otherwise would be due to a deduction on the company's interest. Given that k_v (discount rate) already includes ITS, part of the cash flow to debt and equity investors must come from the ITS to match by adding YT. Therefore--> FCF^u + YT.

To distinguish from the Standard WACC--> The Standard WACC adjusts return to investors by removing the ITS (denoted as -k_dTL) since no part of FCF^u comes from the ITS. The cash flow, therefore, matches the discount rate. This signifies the Standard WACC ignores the ITS in both debt and equity cash flow and discount rate.