DCF: (1) Adjustments to equity on WACC and (2) debt to equity for WACC

Hi,

(1) When calculating %debt and %equity used in WACC, is it acceptable to discount "air money" assets from equity? For example; intangible assets, deferred tax, goodwill, etc

(2) Let's say you perform a FCFF DCF valuation where capital structure goes from 90% debt 10% equity to 90% equity 10% debt: which capital structure do you use for the calculation of WACC?

 
Best Response

Dude, what? You should be using market values of both debt and equity to calculate the relevant percentages. The asset side shouldn't play any part, and ideally, you avoid the balance sheet altogether (except cash to get to net debt).

For number 2: so much going on here. First, you should use the target optimal capital structure, period. If you don't know what that is, ok, you can use an average capital structure over the DVD period. BUT for cases like this where capital structure changes significantly you should drop the DCF and do an APV valuation instead. APV is built to handle changes in capital structure whereas DCF is not.

Hope that helps.

 

(1) Are you saying I shouldn't use the balance sheet figure of equity and of debt to calculate %equity and %debt? Are you saying I should use "enterprise value" as debt + equity and "equity value, based on shareprice" for equity? The company being valued is not public.

(2) I'll look into the APV. Regarding DCF, I understand that an unlevered DCF is OK for companies that change capital structure significantly, while a levered DCF is not as good.

 

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