DCF valuation and the constant WACC assumption

Question

I have a question that has been on my mind ever since I learned about DCF. I was taught that for the DCF to be valid WACC should be constant. As a physicist by training this assumption is strange to me. I understand that having fixed WACC makes your life simple, but shouldn't it be possible to have a changing WACC is the explicit forecast period? Would this work if I:

• Relever the $beta$ every year and thus modify the cost of equity ($r_e$)
• Model chnages in debt cost ($r_d$) as a function of capital structure (this is a challenge itself, if you want to model bankrupcy costs).
• Make sure that that capital structure is stable outside the explicit forecasting period.

Thanks for the help

P.S. I know that there are other methods I could use for valuation like APV which are much easier and allow for changing capital structure.

P.S. 2 In order to keep the model simple, I am always assuming that debt is exogenous and issued at the end of the year (this way I avoid the ciruclarity with interest expense and some other items).

Answer 1

You can indeed have the WACC vary with the capital structure. The problem however lies in the terminal value which assumes a constant into perpetuity. Another issue is that the capital structure ratio used in WACC should be based on the market value of the enterprise, which again itself is dependent on the WACC used. In other words you will have a circular reference, which can only be solved using iteration. Therefore, best use APV.