WACC in a DCF
Hi all - quick question. When calculating WACC for a DCF, do you use the current capital structure of the company, or the post-acquisition capital structure? Thanks!
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Current or industry average.
Or target cap structure, which may be a more levered PF company. Really depends on the situation; typically I have seen WACC builds which look at a mix of different cap structures (current, peer average, target (if different than peer average), so give insight on a reasonable WACC range for a DCF sensitivity analysis
I would argue that in practice, we typically just see the current capital structure used, but in theory, however, I would say you need to use the constant capital structure that will be implemented going forward. In your case, that might be the post-acquisition capital structure (but if it’s getting acquired then certain issues would persist with the cost of equity, in the form of beta, and cost of debt, which will likely require refinancing, but that can be a different discussion). In some ways, WACC is a forecast because it is used to discount FUTURE cash flows, which means that the inputted capital structure should reflect what is anticipated.
Mindful that when the capital structure changes a lot within your forecasts period (i.e LBO), DCF might not be the appropriate method to use
Fortunately you don't use WACC in an LBO my friend; hit me with those levered IRRs every time
Plenty of interns around to play tough cookie on. That's exactly what I said. And took it one step further, DCF is not appropriate when cap structure changes massively. You can have other cases where it changes a lot and it's not an LBO scenario.
Use APV
Don’t know how it’s done in the industry, but the discount rate you use needs to represent the capital structure for this specific year.
Usually a DCF model will assume that there is a target capital structure and so the WACC will be calculated using this target. That makes it’s much easier, because this means that your WACC doesn’t change from year to year.
If your capital structure changes a lot then using the APV (adjusted PV I think) is better because it lets you calculate the value of the debt tax shield separately.
In some ways it depends on what you're doing. If you're looking at a "classic" football field banker DCF valuation then your WACC should be based on the "target" or "optimal" capital structure of the company in perpetuity. Of course the challenge associated with this is that there really isn't a discrete way to actually explain what that is - an "optimal" capital structure that minimizes WACC is almost always going to be way too over-levered for reality. So your "optimal" capital structure is essentially just what you "think" the cap structure should be going forward into perpetuity. For some companies this is more easily determined; for example if companies are always and consistently maintaining certain leverage ratios over a long period of time then it's easy to point to such a history as the "target". Some bankers just use the current capital structure as well to avoid this guesswork.
If you're using a DCF valuation for an LBO, for example, then you'd want to use the entry capital structure but also adjust for the tax shields.
DCF for an LBO? What is this nonsense... LBO is a cash flow model to solve for IRR; WACC is irrelevant. Don't confuse the poor kid
Yes I should've been more explicit in that I was referring to an APV model for a leveraged buyout.
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