hard · Investment Banking valuation-core
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 fully embed the interest tax shield within their calculation, so applying a tax-adjusted WACC to them double-counts the leverage benefit and inflates the resulting firm 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 the 40% target raises the cost of equity used in the WACC blend, which lowers the overall discount factor and mechanically raises every present value across the explicit period
- The higher pre-tax cost of debt that reflects the riskier 40%-levered profile should instead be applied against the levered free cash flows, not the unlevered ones, creating a numerator-denominator mismatch
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