Explain the difference between using actual capital structure and target capital structure in the WACC of a DCF. Give a specific example where using actual would lead to a valuation error.

Actual capital structure is the company's debt and equity mix at the valuation date, based on market values. Target capital structure is the mix the company will maintain over the long run. A DCF discounts long-term cash flows, so WACC must reflect the long-term target. Using actual when the company is temporarily under- or over-levered misstates the cost of capital. Example: a company just completed a leveraged recap and has 70% debt, but plans to delever to 30% within two years. Using actual 70% debt yields a low WACC because debt is cheap and the tax shield is large; this overstates value because the discount rate does not match the steady-state capital structure of the cash flows. The correct approach is to re-lever beta and weight capital using the 30% target.

Follow-up pressure:

• How do you determine the target capital structure for a private company with no stated target?
• If the company is in financial distress and cannot service its debt, should you even use a target structure, or is a DCF inappropriate?