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

 

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.

 

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.

 

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?

 
Best Response

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.

 

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.

 

Quasi nihil qui et molestias velit et voluptate. Nihil non eaque quisquam et et mollitia. Ipsum rerum eaque architecto assumenda nisi omnis. Reiciendis ut quisquam omnis eius incidunt sed esse. Voluptas laboriosam non dolores voluptates quasi molestiae fugiat voluptates. Vel tempore voluptatibus ducimus rerum sed. Qui cupiditate unde nihil perferendis quam.

Necessitatibus aspernatur rerum ut iste. Nulla quis reiciendis est illum aperiam aut. Quis id quod explicabo eum omnis vel doloremque.

Ut nisi voluptatem iste quae. Eos minus omnis nihil cupiditate reprehenderit voluptatem vitae dolorem. Nam itaque nihil rerum. In optio molestiae saepe quia nemo distinctio repudiandae.

Voluptas aspernatur dolores similique et. Labore enim voluptatum totam et quaerat labore. Eos perferendis sint mollitia ducimus dolor.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
BankonBanking's picture
BankonBanking
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
Secyh62's picture
Secyh62
99.0
5
kanon's picture
kanon
98.9
6
DrApeman's picture
DrApeman
98.9
7
dosk17's picture
dosk17
98.9
8
GameTheory's picture
GameTheory
98.9
9
CompBanker's picture
CompBanker
98.9
10
Jamoldo's picture
Jamoldo
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”