A company has a high debt load and is paying off a sig. portion of its principal each yr. How does it affect DCF?
dumb question here: I know it won't affect the unleveled FCF. But how about its WACC? The principal goes down, proportion of debt will go down. Will WACC change in this case as well? The guide didn't cover this part. Am I thinking too much?
If you assume debt is cheaper than equity, WACC will go up. Think about paying off principal - you're using cash (asset) to pay off debt (liability). Your balance sheet decreases in size, with the debt portion of the capital structure eating the whole decrease. This increases the ratio of equity:debt. Understand?
No you're not thinking hard enough.
I'm just kidding.
But seriously.
Wacc will not necessarily go up. As the percentage of debt in the capital structure decreases, the cost of equity decreases. If there was too much debt in the capital structure, paying some of it (to a certain level) may make the wacc go down.
Is this not what I said in my next comment? The simple answer is, in normal circumstances, i.e., debt is cheaper than equity, no financial distress, WACC will go up. If you assume a "weird" situation, this isn't always the case.
No.
Yes.
Normally it will because usually in LBOs you lever up to buy the company and than use it's cash flow to pay down debt. Over the lifetime of the LBO the ratio of debt to equity falls, and as the above poster said, your interest tax shield declines.
Although, if you get asked this in an interview and want to come off as extra sharp, I would say what I just said, but with the caveat that it matters just how high the debt load is. Like, WACC is generally calculated using market prices not cost, so if the company's debt load is so high that people don't necessarily believe in it's ability to pay it back, it's possible that paying down a bit of principle will make the rest of your debt trade at higher levels, which reduces the cost of debt, which would reduce WACC. I suppose you could say that would already be priced into the cost of equity (obviously if the debt holders don't get paid back equity is wiped out so the equity will trade at a discount if this is considered likely) but I don't think most people believe equity markets are perfect. This is just me talking now.
This is a pretty rare situation though, the first answer I gave is the textbook "correct" answer, the second is just more shit to be aware of.
i would just ding you if you told me that bullshit
Good thing 1st year analysts don't interview I suppose. What do you take issue with?
wacc is based on the optimal capital structure... paying of the debt shouldn't effect that.. hence should the wacc be unchanged.
very wrong
If you assume that a company isn't in financial distress, and the cost of equity is higher than the cost of debt, then your WACC will increase as the capital structure changes. The big impact will be the interest tax shield up front, just like an LBO. As your debt level decreases, your interest tax shield will decline. In order to to capture the effect of the change in capital stucture, you'll have to re-weight your WACC every period of your model.
so WACC goes up through the lifetime of an LBO investment?
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