What happens to the present value of cash flows when the WACC decreases?

What happens to the present value of cash flows when the WACC decreases?

• A. The present value increases
• B. The present value decreases
• C. The present value remains unchanged
• D. The present value becomes negative

Answer: (A)

When the weighted average cost of capital (WACC) decreases, the present value of cash flows increases. This relationship is rooted in the principles of discounted cash flow analysis. WACC represents the average rate that a company is expected to pay to finance its assets, and it serves as the discount rate when calculating the present value of future cash flows. When you apply a lower discount rate to future cash flows, it means that the future cash flows are discounted less aggressively. Consequently, each cash flow amounts to a higher present value since their future value is not diminished as much. In mathematical terms, when calculating the present value, the cash flows are divided by (1 + WACC) raised to the power of the number of periods until the cash flow is received. A decrease in WACC results in larger values when you compute this division. Therefore, as WACC decreases, the present value of the expected cash flows rises, thus making the correct answer the increase in present value.

When the weighted average cost of capital (WACC) decreases, the present value of cash flows increases. This relationship is rooted in the principles of discounted cash flow analysis. WACC represents the average rate that a company is expected to pay to finance its assets, and it serves as the discount rate when calculating the present value of future cash flows.

When you apply a lower discount rate to future cash flows, it means that the future cash flows are discounted less aggressively. Consequently, each cash flow amounts to a higher present value since their future value is not diminished as much. In mathematical terms, when calculating the present value, the cash flows are divided by (1 + WACC) raised to the power of the number of periods until the cash flow is received. A decrease in WACC results in larger values when you compute this division.

Therefore, as WACC decreases, the present value of the expected cash flows rises, thus making the correct answer the increase in present value.