To calculate WACC in DCF, should you take Current (Actual) D/E ratio or targeted D/E ratio. I am throwing arguments for both sides and want to take thoughts on what would you take.
Targeted D/E: Because I am discounting cash flows of future periods and hence the D/E should also be forward looking and not as of today to assess the correct risk
Current (Acutal): Since we are valuing the company as of today, only today's D/E should be considered. The change in future D/E gets reflected in the cash flows and hence WACC should be based on actual D/E.
Be careful in your selection as it can change valuation drastically.
Thoughts are welcome!
Hmm just thinking out loud, been a while since I had to do anything like this:
Feels like it should be the targeted D/E for future cash flows, provided the projected cash flows (interest expense, tax, shareholder dividends, etc.) are updated to account for the increased or decreased amount of debt. If the D/E changes gradually over time then maybe using different WACCs for each intervening period is required.
Also could just be me but the explanation for using current/actual D/E ratio seems off. Equity potion of WACC is required rate of return given risk, with higher debt also providing tax benefits, with overall effect being lower WACC for the more debt you have up to the point lenders shut you down. Change being reflected in cash flows only may not fully account for that - higher debt decreases your cash flow, which if discounted at a higher WACC than needed would artificially depress the valuation, or vice versa if debt is decreases. Even incorporating the change in cash for raising or paying off debt neglects the value of the interest tax benefits - overall I feel like if you do it right maybe both approaches could work but it would be a lot easier to just use the expected WACC for targeted D/E, especially for sensitivity analysis.
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