Hypothetical situation: You are valuing a private company for a possible M&A and you receive their business plan which you are going to use a DCF model to gain a general idea of how much value they think the company is worth as-is. The market they are in has a few comparable companies you can use in order to get a beta and a D/E ratio to calculate a discount rate.
However, in the very early years of the business plan they are completely paying off their debt with no future planned borrowings after that. In other words, after the first year or so FCFF and FCFE are completely the same. Only investments are CAPEX to replace depreciation and small amount of WC growing in line with revenue, and the FCFE is all distributed as dividends.
My understanding is when valuing private companies, a big assumption is the average/median D/E ratio of the comps indicates the “optimal capital structure” - but even though this business plan as-is shows no use of debt currently, theoretically they COULD use more debt for future possible growth CAPEX that is just not determined yet and not reflected.
So, is the appropriate methodology to discount FCFF with a WACC and subtract the minimal amount of (in-the-process of being repaid) debt (assume it is net debt for simplicity), or directly discount FCFE with a CoE?
My issue is, since for the majority of the timeline FCFE and FCFF are equal (and the amount of net debt on the BS as of valuation date is not exactly representative of the “optimal” D/E) - the difference comes down to a lower WACC or a higher CoE as the discount rate - creating a considerable discrepancy in results (even though theoretically they are supposed to be near or equal).
Any opinions?