I am working on a DCF model for my company and was struggling finding any information on debt amortization and the changing in the marginal cost of capital.
For the specific project I am looking at, we would be paying down principal on the debt for the project, thus changing our marginal cost of capital for the project (the weights). My belief is that I should be changing the discount rate (marginal cost of capital) each year as the weights of debt to equity change. This would should an increasing marginal cost of capital until the debt is paid off and then growth would be constant.
What are your thoughts on this and does anyone have any literature or resources I could use to research this more in regards to marginal cost of capital and debt principal paydowns?
If the capital structure changes throughout the life of the project, use the Adjusted Present Value (APV) model instead.
Yes, for a robust DCF, you’d need not only to adjust the weights, but also the cost of equity (as the financial risk decreases, so should the cost of equity, though the relationship is not linear) as well as the cost of debt (lower leverage means lower yields). You also need to change the beta, since you need to de-lever your day 1 beta and re-lever to factor in the current year’s debt level.
So the analytics are delicate and none of this is exact science. Your best bet I’d say is to estimate the day 1 WACC, then the WACC at the time of the terminal value, then do some linear interpolation between the two over the forecast period if the cashflows move on a consistent manner. It is not 100% strict analytics, but it will be a lot easier to understand, including for any client you pitch to, who can follow your logic and accept the. results.
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