hard · Investment Banking
An analyst is building a DCF and computes WACC using a target capital structure of 40% debt. The company is currently 20% debt-funded but management commits to the 40% target. A junior banker re-levers the equity beta to the 40% target, applies a higher pre-tax cost of debt reflecting the riskier 40%-levered profile, and discounts the explicit-period unlevered free cash flows at this single WACC.
Holding all else equal, why does this approach most likely OVERSTATE the value of the firm relative to a theoretically correct treatment?
- The unlevered FCFs already embed the interest tax shield, so applying a tax-adjusted WACC double-counts the benefit of leverage and inflates value
- Using a constant 40% WACC assumes the target structure prevails throughout, but the firm is only 20% levered today, so the early-year tax shields are smaller than the constant WACC credits, overstating value
- Re-levering beta to 40% raises the cost of equity, which lowers the discount factor and mechanically raises every present value in the explicit period
- The higher pre-tax cost of debt should be applied to the levered free cash flows, not the unlevered ones, so the cash flow numerator is mismatched with the denominator
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