Hi all I have the following interesting hypothetical and was wondering what you would do in this instance. Say a valuation is performed on company QWE. The company has been insanely profitable and is privately held. No dividends have ever been declared and the company only has minor debt, which it managed to get at a reduced rate. The result is that debt to equity stands at 8% to 92%. As a result the WACC is heavily influenced by the equity side with cost of capital on that side being higher than on the debt. Now here is the kicker, shortly after the valuation the company intends to distribute some of that cash to its shareholders. The result of this will be a change in the debt equity relationship, bringing the equity percentage down and the debt up. Since the cost of capital on the debt is lower the WACC will be lower. Since future cash flow is now discounted at a lower rate the value of the company will be higher after the dividend payment than before it, which is of course not possible. I have a solution in mind but what do you think?
use the company’s targeted long term capital structure as your weights… or check what the comparable structures are in the industry and say here’s what the company is worth in their current structure. Here’s what it’s wroth if you don’t participate in the cash distribution and then here’s what its worth if its capital structure aligns with its comps.
MM Proposition # ? Paraphrasing, there is an ideal D/E ratio, and presumably it is greater than 8% Debt and 92% Equity. They can boost their equity up to, who knows, 25% while still lowering the WACC and not yet incurring the costs of being overleveraged. Real rough paraphrase, but check out the MM propositions.
Good call, doing so now.
I think MM props are only for ideal world where there is not tax implications. Practically you should use what strikershank says.
Be sure to calculate an unlevered (industry) beta and relever it to different D/E when estimating the cost of equity. The interest rate for debt will probably also change when you put on higher leverage. Perhaps the WACC will not change THAT much after all.
The cost of equity may also increase if you look at it from the Growth model. If the increase in Dividend yield over P /E exceeds the decline in growth, then r should go up.
Sort of a long the lines of what other said the MV of the debt would decrease so the cost would be higher. Look at the cost of debt when a company does a dividend recap. While not the same here, it’s a similar idea.