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Changing WACC in DCF Forecasts and the Terminal Value Problem

Article Quant Q&A · Author: Mark
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Summary

The document considers whether a discounted cash flow model can use a changing weighted average cost of capital during its explicit forecast period. The proposed approach would update equity cost by relevering beta each year, adjust debt cost as capital structure changes, and hold the capital structure stable beyond the forecast horizon. It also notes that assuming debt is issued at year end can avoid some circularity involving interest expense.

The answer says WACC can vary with capital structure, but highlights two complications. A terminal value based on a perpetuity still requires a stable assumption, and the capital structure weights in WACC depend on enterprise market value, which itself depends on the discount rate. That feedback creates a circular calculation requiring iteration. The answer therefore recommends adjusted present value as a more suitable method when capital structure changes. No numerical example or comparison of valuation results is provided.

Key ideas

  • WACC can vary during the explicit forecast period as capital structure changes.
  • The terminal value still requires assumptions about conditions beyond the forecast period.
  • Market value based capital structure weights create circularity with the discount rate.
  • Iteration can address the circular reference, while APV is suggested for changing capital structure.

Tags

EquitiesFixed incomePortfolio construction
Full text
# DCF valuation and the constant WACC assumption


# DCF valuation and the constant WACC assumption












I have a question that has been on my mind ever since I learned about DCF. I was taught that for the DCF to be valid WACC should be constant. As a physicist by training this assumption is strange to me. I understand that having fixed WACC makes your life simple, but shouldn't it be possible to have a changing WACC is the explicit forecast period? Would this work if I:

- Relever the $beta$ every year and thus modify the cost of equity ($r_e$)

- Model chnages in debt cost ($r_d$) as a function of capital structure (this is a challenge itself, if you want to model bankrupcy costs).

- Make sure that that capital structure is stable outside the explicit forecasting period.

Thanks for the help

P.S. I know that there are other methods I could use for valuation like APV which are much easier and allow for changing capital structure.

P.S. 2 In order to keep the model simple, I am always assuming that debt is exogenous and issued at the end of the year (this way I avoid the ciruclarity with interest expense and some other items).

## Answer by Matthias (score 1, accepted)

https://quant.stackexchange.com/a/65496

You can indeed have the WACC vary with the capital structure. The problem however lies in the terminal value which assumes a constant into perpetuity. Another issue is that the capital structure ratio used in WACC should be based on the market value of the enterprise, which again itself is dependent on the WACC used. In other words you will have a circular reference, which can only be solved using iteration. Therefore, best use APV.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.