Module II· DCF — Mechanics & FCFIntermediate
Question
What implicit assumption about reinvestment is built into a DCF?
Answer
Mechanics
Implicitly, you assume that every FCF generated can be reinvested at the WACC. In reality that is rarely the case — excess cash is often parked in money-market accounts (1–3% return), not reinvested at a 9% WACC. Implication: DCF values are a theoretical 'top-of-range' value. Ignored in practice, because the correction is complex and the assumption about reinvestment opportunities is speculative. A similar problem arises with MIRR (modified IRR) for PE returns.
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Pitch tip
On the question 'What are the weaknesses of a DCF?', the reinvestment problem is a subtle point that shows you understand the theory.