Be careful with the target debt in wacc

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Be Careful with the Target Debt-to-Value Ratio in
Calculating the Weighted Average Cost of
Capital (WACC)
Weighted Average Cost of Capital (WACC) is very dominant being taught in all finance classes,
and in general, following Modigliani-Miller (M&M)-version of WACC, the formula is as follows:
WACC has been used as a constant discount rate for Net Present Value in capital budgeting
analysis or as discount rate in Discounted Cash Flow (DCF)-based Firm Valuation.
Though this traditional or standard M&M version looks simple, as all we need are only the
following components:
i. Cost of debt (Kd) = the required return asked or demanded by the debtholders for them
to be willing to lend their money to the company to finance the project.
ii. Marginal corporate income tax (T).
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iii. Cost of levered equity (Ke) = the required return asked or demanded by the common
equity holders for them to be willing to be separated from their money, and invested that
money into the project.
iv. Debt weighting or proportion to the total value of project (Debt to Levered Equity, or
D%). This reflects the financial leverage of the project, or the fraction of the project value
to be financed by Debt.
v. Equity weighted or proportion to the total value of project (Equity to Levered Value, or
E%). This reflects the fraction of the project value to be financed by Equity.
Though it looks simple, but behind this simplified calculation of WACC for the discount rate,
there lies so many assumptions.
Here, I want to touch slightly on the D% and E% estimation that many analysts just jump to
using the industry [historical average] debt ratio, or any target debt-to-value ratio.
I give one example, which shows that the determination of D% and E%, though could give
positive Net Present Value, it just doesn’t make sense.
I always like to ask analysts when they prepared the NPV analysis for capital budgeting, that is :
how they are going to finance the project? Easy question, but in reality, the answer is not always
easy.
Why, unless you have a deep pocket, then in general, I could say, we need to go the banker to
finance the project.
Back to the WACC with its constant D% and E% assumption, then in order to maintain its debt-
to-value ratio, the company must raise new debt with certain % to the value of the project.
Let’s use the example below.
With a total levered value of the project of 122, less the initial investment of 42.50 (t=0), then we
will have a very good Net Present Value, this is 79.50. I could say, the analysts could smile up
when presenting this analysis. The project, while only needs investment of 42.50 at t=0, could
generate positive projected cash flows with its cash value at t=0, totaling 122, almost 3x bigger.
So, we have a “cool” project that looks good to everybody in the room.
D% and E% in the analysis indicate 50%:50%, which looks not too bad, at least, for bankers,
they don’t have to finance that “risky” project with more than 50%.

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Back to my question above to the analysts: How are you going to finance the project?
With a total levered value of the project of 122 at t=0, then D% = 50%, requires the company to
borrow an amount of debt totaling 61. Because the project will need only 42.50 for the initial
investment, then the company has more than it is needed, that is 61 – 42.50 = 18.25 (cell F25).
To be consistent with the D% and E% assumption in the WACC calculation as a discount rate
for the NPV analysis, then this excess money of 18.25 should be given to the common equity
holders (either through dividends or share repurchase).
Amount of Debt of 61 could also be obtained from the following calculation:
 initial investment needs = 42.50, and debt contribution = 50% x 42.50 = 21.25
 the project’s NPV = 79.50, and debt contribution = 50% x 79.50 = 39.75
TOTAL DEBT CONTRIBUTION = 21.25 + 39.75 = 61 (=50% OF TOTAL LEVERED
VALUE OF THE PROJECT OF 122 = 50% x 122 = 61, the same amount contributed by
your banker, in order to get 50%:50% for project financing)
How about the common equity holders?
By undertaking the project, the company adds new assets to the firm with initial market value (at
t=0) of 122, and with E% = 50%, then equity will increase by 50% x 122 = 61, and with the
money received from the company (either through dividends or share repurchase) of 18.50 (see
above calculation), or in total = 61 + 18.50 = 79.50, which is exactly the same with the NPV of
the project. This result is not surprising knowing that NPV all belongs to the common equity
holders.
But, wait a minute, don’t be impressed with the calculation above. We need to stop a while…
You should be able to see that the above scenario with D% : E% = 50% : 50%, doesn’t make
sense.
The part that does not make sense, is the flow of money from the company to the common
equity holders at t=0, that is 18.50, the money is obtained from raising the new debt. It means,
the amount of debt at t=0 that is required to maintain the project’s target debt-to-value ratio (in
this case D% : E% = 50% : 50%) as explicitly stated in the WACC), the company should raise
new debts from the bankers totaling 61 and then give 18.50 to the common equity holders
directly.

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In reality, this can’t happen. No bankers want to give the money to the company to finance the
project, knowing that a portion of the money lent to the company, will instantly be distributed as
dividends or share repurchase, going straight to the pockets of the common equity holders.
So, it is so crucial to see again the impact of your assumption for D% : E% being used in the
WACC calculation, to see whether it makes sense or not.
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