How are future debt/claims accounted for in UFCF DCF?
Hello everyone, sorry for posting this in the IB forum (not sure where else to post), but I've been struggling with this concept for the past few days.
When looking at a DCF valuation using UFCFs, we use the WACC to get Enterprise Value (EV). We extend that the WACC is appropriate to use here because UFCFs represent cashflows to all investors from core operations and therefore should be discounted at the rate of return required by investors on their investment. Obtaining the implied EV, we then can compare to the market value of Debt and Equity, to see if investing in the capital structure (or equity only) is an appropriate choice, as they receive all the UFCFs.
Yet, where it seems to break down for me is that if we see the capital structure as an investment, the debt portion does not reflect a perpetual investment unlike equity. It's not like buying up the entire capital structure today at market values will entitle me all the UFCFs (which are forecasted in perpetuity), because the debt portion I buy today will ultimately be repaid, and new debt will be issued that I don't own.
Thus, how is the discounted UFCFs comparable to existing debt such that we may subtract debt from implied EV to get implied EqV? Additonally, why is future debt issuances ignored in calculating equity value today? (Afterall, the WACC assumes constant capital structure w.r.t. firm value)
I've tried to look at Damodaran's textbook and the best I found was "A question that arises then is whether you should be subtracting out the value of these future debt issues when estimating equity value
today. The answer is no, since the value of the equity is a current value and these future
claims do not exist today".
Also the McKinsey book list a requirement of DCF with UFCFs that "The duration of the securities used to estimate the cost of capital must match the duration of the cash flows."
Admittedley, I've also looked at excel files that reconcile UFCF and LFCF discounted cash flow methods, and under the same assumptions, the implied equity value are the same! Thus, it seems that UFCFs DCF is consistent with new debt issuances.
Clearly, the methodologies described has theoritical foundation, however after looking at multiple material I still can't seem to pinpoint it and get an intuitive understanding. Any clarification is much appreciated!
Bump. Appreciate any advice on how to view this!
Bump
Anyone? (sorry for the bumps, this will be the last)
Hi Korern! Have you found the answer to this question?
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