Which D/E ratio should I use on a 3 year projection of the following?
Hey all,
I've been tasked to do a DCF to attain the enterprise value for a company. I'm trying to calculate the proper WACC to discount my future cash flows but I have some tricky inputs (all assumptions given).
Year 1: The company takes a loan for $10,000,000 and gains equity from investors worth $10,000,000
Year 2: The company repays $5,000,000 of the loan
Year 3: The company repays $5,000,000 of the loan.
Now I'm trying to get an enterprise value, and I calculated what the FCF's are, but now I need to discount them at WACC. I know my cost of equity and I know my cost of capital, but what weights do I use when calculating WACC?
Edit: Additional Information
Levered Comparable Beta: 1.10
Market debt to equity ratio: 0.40
You use the weight values from year 0. So if the company is currently financed 50/50 then you use those weights for the WACC. I think...
Thanks boss.
WACC should theoretically be calculated with target capital structure weights as opposed to current weights (this makes sense when you consider the fact that a lot of the valuation comes from the terminal value). So, you should probably just ignore the temporary loan assuming that the firm doesn't expect to absorb additional debt into the capital structure.
But what would the D/E ratio then be if they are debt free in year 3? Would you actually assume 100% of financing is coming through from equity and make the cost of capital equal to the cost of equity? I have to work with the assumptions i'm given. Also, how do you calculate the "target" capital structure? Is there a specific formula? My guess would be to keep the cost of equity and cost of debt the same, and then attempt to adjust the weights to see which result gives you the best WACC?
I think it's the other way. Just learned you use the newest capital structure (not in IB yet, so take that with a grain of salt), so if you know the company issues equity or takes on debt, adjust as far in the future as possible. In this case, they pay off the debt entirely, so you are left with just the 10m gained in Equity. My question would be is this considered a subtraction to common stock?
No - I'm sure, Its target cap structure - I don't understand your question. Are you asking for the journal entry? If you simply pay off in cash you don't report any additional equity (assets decrease by as equal amount as debt decreases), unless you assume that the firm issues equity in order to pay off debt.
'The market values of equity, debt, and preferred should reflect the targeted capital structure" http://macabacus.com/valuation/dcf/wacc
But what would the D/E ratio then be if they are debt free in year 3? Would you actually assume 100% of financing is coming through from equity and make the cost of capital equal to the cost of equity? I have to work with the assumptions i'm given. Also, how do you calculate the "target" capital structure? Is there a specific formula? My guess would be to keep the cost of equity and cost of debt the same, and then attempt to adjust the weights to see which result gives you the best WACC?
There is no method to determine the Target Capital Structure short of due diligence/requesting information from the firm. Do we assume that the firm takes on no additional debt after its initial financing? If so - assume target D/E = 0, just use the cost of equity to discount.
Thank you very much sir. Loved the lesson here!
Comps analysis is often used for target capital structure, but then you'd need to adjust based on the risk aspirations of management etc.
This is also true - do you have any further information regarding comps capital structure?
We got the blind leading the blind in here. Lever up at the target capital structure.
All equity is also going to be a higher WACC, as long as D/E isn't too big, so it's going to give you a more conservative valuation.
You could also use APV if you want because that accounts for changing capital structure.
Levered Comparable Beta - 1.10 Market Debt to Equity - 40%
But if I unlever this comparable beta at the market debt to equity ratio, i'm left with an unlevered beta for which I am free to lever at my "target" capital structure. But technically, if I already unlevered at the target structure (0.40), what is left to lever with?
You unlever at your current D/E because you want to take your capital structure out of the equation so you're only left with equity. Then you relever using your comp D/E because you want your future capital structure to be similar to the rest of the market.
So you start by unlevering using your current D/E which is 1. So, assuming you incorporate a 30% tax rate, your unlevered beta is 1.1/1.7 = ~0.65. So then you'd relever at the comp D/E and your beta is ~0.85.
What's the logic in unlevering a comparables beta at my debt to equity ratio? His levered beta is what it is because of his capital structure, it seems illogical to unlever it at my current debt to equity ratio.
Is this assuming that my debt to equity ratio was embedded in the levered comprable beta / industry comparable beta (assuming they are the same in this context as the given is limited)?
Why would you unlever the industry's average beta at my company's current capital structure? You unlever it at the industry's average capital structure (because it is levered at the capital structure of each of the peers in the sample).
I think I understand what is going here guys.
1) The levered comparable beta is a proxy to the industry comparable beta since no additional information is offered here. Is this assuming that my debt to equity ratio was embedded in the levered comprable beta / industry comparable beta (assuming they are the same in this context as the given is limited)?
2) The industry comparable beta embeds average capital strucutres of all the firms in the industry, and apparently the average D/E ratio is 0.40 based on the given.
3) Its my job to remove my capital structure from the equation, accordingly I do and take the 1.1 and unlever it using a DE ratio of 1. I get an unlevered beta and now I re adjust it using 0.40 debt to equity ratio.
Why is the beta unlevered using a DE ratio of 1 instead of using the .40 DE ratio?
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