Which D/E ratio should I use on a 3 year projection of the following?

Question

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.

Greg Marmalard · Accepted Answer

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.

Go-Gorilla · Answer

To cut through the confusion JoeySalads, what Greg has added to the discussion is this: In the absence of industry comps/management guidance/any further information regarding optimal capital structure, assume that the optimal capital structure (the capital structure that you should use the calculation of levered beta and WACC) is the market capital structure.

JoeySalads · Answer

Ok but here is my confusion. Based on my given, I do not have a levered beta, unless you mean "yours" as in the given and not my firm. So is this what you're thinking:

Step 1) Unlever comps  levered beta of 1.1 (i.e markets) at D/E ratio of 1

Step 2) Relever that unleverd beta at a debt ratio of 0.40?

JoeySalads · Answer

I believe it is because if you want your target structure to be like the market, then that would be your relevering rate. You need to ponder, all my future cash flows are going to be discounted at a rate, that rate realisticly should be close to the market, and thus to embed this idea we need to have a beta which is levered at the market rate. Simultaneously, we cannot ignore our debt to equity ratio which is currently 1 at year 0.

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Which D/E ratio should I use on a 3 year projection of the following?

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Which D/E ratio should I use on a 3 year projection of the following?

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