Calculating EV....Mkt Cap in WACC calc....?
Morning! First time user here. I work in corporate finance and I'm leading an initiative to enhance our business valuations. I've developed a DCF model and while building out the WACC formula, I started to ask myself questions that I could not answer (nor find the answer online).
When building out the WACC, we must determine the cap structure of the firm (% debt / equity). However, the "equity" used is the market value of its equity (to eliminate the pitfalls of GAAP). The problem I see here is that my ultimate goal is to compute EV, which as you know is Mkt Cap + net debt. So if I'm using the market equity (mkt cap) in my WACC calculation, which ultimately drives my EV, wouldn't this be a problem?
Thanks in advance for your input Rick
You select your target, ideal capital structure. If this isn't something that's clear to you, then you can select the average/median leverage ratio of your closest competitors.
I'm not sure I fully understand your question, but it shouldn't matter because with a DCF analysis, you're defining enterprise value as the present value of the firms future cash flows. Because you're talking about an unlevered DCF, the free cash flows you're discounting represent cash available to all investors of the company (equity, debt, etc).
WACC is simply the discount rate used to find the present value of the uFCFs, and since the cash flows are unlevered, you must use a rate that reflects the opportunity costs that both equity and debt investors are undergoing by investing in this company over another. WACC is the weighted average return rate that investors could be getting if they invested elsewhere.
Let me know if this helps.
Well, the underlying assumption when using the WACC method is that you maintain a constant capital structure for the rest the company's live (i.e. the company instantly adjusts to any fluctuations in equity value by buying or selling debt). So, as Esuric said, you choose your target capital structure and use that in your calculations.
On a side note, think about how realistic this assumption is in the real world.
Thanks for the responses. I guess I'm having a hard time explaining. The goal of the exercise (for me) is to get an independent valuation, rather than relying on the EV that you can find on CapIQ/YahooFinance. As you mention, we calculate unlevered FCF, then discount it back to its PV based on the WACC we calculate. However, part of the WACC calculation is determining the capital structure of the firm. Traditionally, when calculating D/E and D/C we define equity as its market cap. If I'm using the company's market cap, I'm essentially relying on the street's value and thus not being independent.
I guess I have a few options: - Keep using the firms mkt cap in the WACC calculation - Use the peer average capital structure (which would then rely on the market cap's of those firms) - Make a judgment on what the optimal structure would be, which would be hard to support.
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