Actually, you are not entirely correct. One method of valuing a company is called the "free cash flow method", and it uses WACC as its discount rate. The theory behind doing so is that a company could arguably be broken down into a collection of projects. So you basically discount the free cash flows by the firm's WACC, add and subtract a couple of things to get value of the overall equity of the firm, then divide by shares o/s to get a valuation per share. And yes, a change in ratings could increase the cost of debt for a firm, which would increase its WACC and therefore decrease the firm's value.
There's a line of thinking that considers ownership of a stock to be equivalent to owning an option on any future cash flows. It is interesting.. wonder if anyone here has experience with it?
I've studied options a fair bit academically (happen to be covering real options right now for example), and that is an interesting concept. I'll have to think about this one a bit and get back to you. I can also say that I haven't run into any textbook stuff yet at the undergrad level relating to this.
Yes I know FCF, it is the most preferred method but it is not as good as ppl think. As someone who recently had to evaluate a company in order to understand what would be a proper investment for 50% of the company, FCF does not do it because of the accounts receivable turnover vs inventory turnover. In this unique case, the accounts receivables in question are guaranteed. I had to use pre tax Net Income with conservative growth rates and profit margins. Another problem with FCF is how are you gonna predict the future capital expenditures. It's not so easy in a developing company and completely subjective. Whole valuation process of a stock is really what you want it to be and what gets your point across. That is what IBs do, they pick out the best method that best gets the best deal. It's all subjective, thats the best advice I got from my IB friend when I posed this question to him. You can use whatever you want to because after all, it's a question of who the answer is being presented to. I, personally, would not use WACC as the discount rate because I am not the firm, I have my own discount rate based on my investments. If the proposed investment has a high inherent risk, I would naturally require a higher discount rate. Simply put, if there was a set formula for evaluation, there would little speculation. FCF works great for stable companies and if you actually perform FCF valuation for 10-15 year timeframes for companies like INTC, CAT, EBAY, YHOO you will come quite close to their current market prices. Institutions have daily evaluations done on these companies, so sometimes they hold these companies in line.