Is non-linear WACC covered in CFA curriculum? Has anyone of you used it at work for a DCF model?
I am valuing a company which goes from 1:1 D/E to 0 in about 5 years time. Will it not be prudent to have a differet WACC for the forecast period depending on the leverage? Of cource for the terminal year we can have the Normalized/Target D/E ratio.
I was trying to find more about NLWACC, probably with some examples but it seems there has not been much research done on this.
Thanks!
Hi,
as far as I know this topic is not covered in the CFI curriculum.
In practice when you have significant changing capital structures and you want to use the WACC method what you use is an annual adjusted WACC. This is done by applying the so called rollback method where you calculate the market value of equity and market value of debt for each period, starting with the last period and rolling back to the first. Then you calculate the WACC based on each specific D/E period ratios.
Note that you have a circularity problem here since you need the market value of equity for each period to calculate the WACC and and vice versa. In Excel this can be resolved however very quickly using the built in iterative option.
In Europe this approach (which is theoretically the correct way to calculate the WACC) is used more often than in the US, where you often see a more pragmatic calculation where an implicit capital structure or an average of the future capital structure is applied.
Best,
Oscar
Or you could just use equity cash flows and discount at cost of equity.
Not really! Bear in mind that the beta factor (systematic operating and financial risk) and hence the CoE depend directly from the applied leverage of the company (D/E ratio). Hence the approach using the Flow to Equity model is the same as for the Flow to Entity (WACC) model as decribed above (rollback model with individual discount rates for each year).
One solution would be to use the APV (Adjusted Present Value) Model instead where you separate the value of the unleveraged company from the value of the debt and the value of the tax shields.
Best, Oscar