Target vs Current Capital Structure Weights in WACC
WACC should reflect the debt-to-equity mix a company intends to run over the long haul, not whatever mix happens to be sitting on today's balance sheet, because today's mix can be a temporary distortion.
Prerequisites: Estimating the Cost of Debt
WACC blends the cost of equity and the cost of debt, weighted by how much of each a company uses. The obvious way to get those weights is to look at today's balance sheet — current debt divided by current market value of equity. But "today" can be a misleading snapshot: a company mid-way through a leveraged buyout, one that just issued a wave of debt to fund an acquisition, or one sitting on an unusually large temporary cash pile, all have current capital structures that don't represent how they'll actually be financed over the many years a DCF is discounting.
WACC should use the capital structure the company is expected to hold on average over the forecast horizon — its target structure — not necessarily whatever debt-to-equity ratio happens to show up on this quarter's balance sheet. Current weights are the right choice only when the current structure is genuinely representative of the long run.
Why the choice matters
The whole point of a discount rate is that it reflects the risk of the cash flows being discounted over their entire life, not the risk of the company at one single moment. A company financed with 70% debt this year because it just closed an acquisition, but planning to pay that debt down to a normal 30% over the next three years, should be discounted at something close to the WACC of a 30%-levered company for most of the forecast period — using the current 70% weight would apply an inflated cost-of-equity-via-beta and an overweighted, temporarily cheap cost of debt to years where neither actually applies.
Comparable-company target ratios (the median debt-to-equity mix of similar firms in the same industry) are the standard proxy when a company's own long-run target isn't otherwise stated by management.
Worked example
A company just financed a large acquisition almost entirely with debt, leaving its current capital structure at 65% debt / 35% equity, market-value basis. Its after-tax cost of debt is 4.5% and its cost of equity, using a beta re-levered to this temporarily high leverage, is 14%.
Current-weighted WACC = .
Management has stated a target of paying down debt to a long-run 30% debt / 70% equity mix within three years, matching its industry peers. At that target structure, cost of debt stays roughly 4.5% but cost of equity, re-levered to the lower 30% debt weight, falls to about 11% (a lower beta since less leverage means less amplified equity risk).
Target-weighted WACC = .
Using the current, temporarily debt-heavy structure understates WACC by over a full percentage point relative to the structure that will actually apply for most of the forecast period — and a lower WACC mechanically inflates the DCF's enterprise value.
What this means in practice
Analysts valuing a company that recently released a large debt or is going through an unusual financing event — post-LBO, post-large-acquisition, or holding an abnormal cash balance — should check management guidance, credit rating agency commentary, or industry peer ratios for a sensible long-run target, rather than defaulting to the current balance sheet mix.
Blindly using current market-value weights is fine for a stable, mature company whose capital structure isn't in flux — the mistake is applying that same shortcut to a company mid-transition, where today's balance sheet is a poor stand-in for the structure that will actually prevail over the forecast horizon.
Further reading
- Damodaran, Investment Valuation (ch. 7, target debt ratios)