D/E weights in WACC formula

If a company currently only has $200 million of bank debt at 8% coupon rate and DOES NOT plan on issuing anymore debt in the future, what amount of debt should I use in my equity beta and WACC calculation?

Also, since the company doesn't have any bonds outstanding, can I just use the book value of this debt?

I know the firm's cost of debt should reflect the average future long-term cost of debt, but since the company doesn't plan on issuing any more debt in the future, should I just use the coupon rate on the existing debt?

In general, is it better to use the target capital structure or the current capital structure in market value? I know market value is the common approach, but given the volatility of the market, I feel like using market value can sometimes imply a distorted D/E ratio that is not consistent with the target capital structure.

Thank you for your input.

Comments (10)

Jul 7, 2009

I think WACC only concerns current outstanding debt, so even if they plan on issuing trillions of dollars of debt it wouldn't affect WACC until it is actually issued.

Jul 7, 2009

But I though the "cost of debt" component of the WACC formula is supposed to reflect the EXPECTED average long-term capital structure of the firm?

Jul 8, 2009

You use target structure... now you're going to ask how you compute a "target" structure... off of market ratios like a Coverage Ratio...

then you use the market value of Equity to calculate the calculated Debt capacity to the equity...

Jul 8, 2009

A couple of points here, lets go in order:

You seem to be confused. You should UNLEVER the comps' betas at the respective comps' CURRENT debt/cap ratio and RELEVER the beta at the target Company's target debt/cap ratio.

The WACC is meant to be calculated in perpetuity. Therefore you should always use the target cap structure (debt/equity weights) and the interest rate associated with that target cap structure.

If the Company does not EVER plan on issuing more debt, then the target debt/cap ratio is likely lower than the existing debt/cap ratio. This of-course assumes that the Company continues to grow (i.e. market cap continues to expand), which means the debt/cap will continue to decline into the future.

If the above is true, the interest rate corresponding to the target cap structure is also likely lower than the rate that exists today. As the debt/cap ratio falls, the Company becomes less risky from a fixed income perspective, and the interest rate should therefore fall as well.

I find the above scenario unlikely. Financing an enterprise with just equity into perpetuity is an expensive (and frankly, unintelligent) proposition.

More likely is that management expects the Company to maintain the current debt/cap ratio into the future. If this is the case, then you could use the current debt/cap ratio as the target debt/cap ratio, and the current interest rate (i.e. 8%) as the target interest rate.

Make sure that the current debt/cap and interest rate are "normalized". If the current market cap is deflated (i.e. due to horrible market conditions), the target debt/cap should be lower than the current debt/cap. If the current interest rate is deflated (due to exceptionally low ST LIBOR rates) the target interest rate is likely higher than the current interest rate.

Jul 8, 2009

Thank you all for your answers.

My understanding is that the company plans on paying down its existing bank debt and then not re-issuing anymore debt in the foreseeable future (NEVER is probably a strong word).

However, doesn't this imply that its target capital structure is 100% equity? If so, shouldn't I omitt debt completely from my WACC?

This is what confuses me. If I calculate WACC for the company as a going concern, I feel like I should include 0% debt, but obiously they DO have debt on their current balance sheet and there is no telling what exactly is going to happen in the future.

Omitting debt completely feels wrong, but that is the target cap structure I hear the company wants to have.

angry_keebler, you mentioned that I should use a lower cost of debt to reflect the lower risk of a declining D/E ratio. How should I compute this cost of debt. The company has no outstanding bonds or credit rating.

Should I look at the company's coverage ratio and try to compute the defauly spread to add to a risk free rate?

Thanks for your help.

Jul 8, 2009

look at the market coverage ratio and use this to determine a debt amount... it is not going to be the same as that of the Company... by using this u find the "target" debt structure as per market conditions, the one you need for a DCF, irrespective of the Company's current debt structure...

Jul 8, 2009

MezzKet, could you please explain more specifically how you would calculate the target cap structure?

Jul 9, 2009

The target capital structure is simply the median debt / equity ratio from the comps. You assume that over time, the company will become like its peers.

Jul 9, 2009

take for example your S&P LCD Comps say the market is issuing debt with a coverage ratio of 2.0x which means EBITDA / Interest = 2.0x...

cost of debt = 6%
EBITDA = $10m
Mv of equity = $100m

$10m / 2.0x = $5m of interest
$5m / 6% = $83.3m of ideal debt

Target Debt / Equity as per market conditions is now 83.3/100 = 83.3%...

Now you create sensitivities on the coverage multiples to see various d/e scenarios...

Jul 9, 2009