Large future debt payment doesn't affect unlevered CF in a DCF. What about levered and WACC?
While unlevered CFs are immune from a company having to do a large debt repayment in the future, how about if I am using levered CFs for my DCF?
Will my WACC change as well?
Does this mean that DCF is an inappropriate valuation method if there is a large debt repayment in the foreseeable future? Thanks so much.
I don't think so. You don't use a DCF for financial services companies because they don't reinvest debt. Maybe an EVA model would be better, as it doesn't include debt.
Sorry, what does "I don't think so" refer to?
I don't think a DCF is an inappropriate valuation, unless it's a company that has debt on their BS like a financial services company.
Ask yourself if you have reason to take a view that the company will actually repay the principal amount vs just refinancing it. Why would they alter their capital structure? If they wouldn't the principal payment can be ignored because they'll just re-borrow the same amount.
Assuming the debt is not refinanced.
If it's FCFF then no impact. If it's FCFE then there is impact on FCF but you'll use cost of equity to discount it so nothing to do with WACC.
Hey zhenqi! Thanks -
1) Won't the change in WACC affect the PV of FCFF? 2) greed that WACC is irrelevant in the case of FCFE. But what about the actual cash flows - won't the FCFE flows become smaller due to the large debt repayment?
Companies repay/take out loans every day. A DCF will only include interest when doing FCFE as FCFF ignores interest payments. FCFE is discounted at the cost of equity so WACC doesn't come into play but regardless the WACC wouldn't change. You do not include principal amortization in the DCF as that is a cash flow/BS change. If you repay the loan during the discreet discounting period in the DCF your FCFE would go up as you no longer pay interest in the later years.
Understood on the interest payment affecting levered cash flows. How about the actual principal payments?
Why would WACC not change for unlevered CF? Wouldn't the capital structure change as you pay off debt?
So you are right that technically capital structure can change over the discrete period of a DCF. However recalibrating the WACC each period is something that is generally not done in practice, at least in my experience. In order to recalculate the WACC each period you would need to estimate the future risk free rate, future market risk premium, future comparable betas, and tax rate assumptions. All of these things are hard to estimate correctly in the future and therefore most people just use the current business' WACC. In addition, some loans aren't amortized they're refinanced to the same level or only paid off upon exit which means the firm has more-or-less the same capital structure throughout the discount period.
Are you asking if WACC should change over the projection period as the forecasted capital structure changes? If so, the answer is no. You don't project WACC for each forecast year and discount the respective cash flows with that rate. Cash flows are discounted with the CURRENT WACC because that is the rate that represents the opportunity cost/cost of capital given the company's current capital structure, which definitionally yields the present value.
Thanks so much!
You need to use the company's target capital structure when you calculate your cost of capital in your DCF -- not the current capital structure, which is clearly changing in this case.
So with large debt repayments that alter my company's cap structure significantly, a DCF is no longer appropriate?
Est nemo et mollitia temporibus. Aliquam nihil quo unde molestiae ut consectetur culpa. Ducimus quae et nesciunt est.
Magni doloribus quia aut enim. Facilis voluptas unde laborum atque et ut et. Asperiores ullam veritatis quia non a natus. Excepturi quidem debitis incidunt et corporis est exercitationem.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...