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Debt Rebalancing in Free Cash Flow Approach
The WACC concept assumes that debt is always a constant proportion of the value of a project. This means that with the changes in project value, the debt value must change to keep the WACC value as it is. For example, with a debt proportionality value of 60% for a project, the value of debt must remain 60% of the project value each year. This means that even with reducing project value, the amount of debt value should change in a proportion of 60%.
Why Do We Need Debt Rebalancing?
We need to tweak the debt proportion value in order to keep the debt proportionality intact while evaluating an investment project. The debt value attached to the project value goes down with each passing year of a project. This happens because the project value itself gets reduced every year, and keeping the proportionality value intact requires reducing the debt attached to the project. That is why, debt rebalancing is necessary in case of capital structuring of a project.
In general, the debt value attached to an investment goes down until it reaches a zero at the end of the project.
For example, if there is an 8-year-long investment project, the debt value of this will be the greatest at the start of the project (the start of 1st year).
It will go down in the beginning of 2nd year and so on until it reaches a value of zero at the end of the 8th year.
So, with reducing debt, its proportionality must also reduce with each passing year to keep the WACC and project value constant.
Debt Rebalancing is Not Required in FCFs
In case of Free Cash Flows, there is no need to tweak the debt part because the FCF approach already takes care of debt, interest, and interest tax shields. In FCF project capital structure is taken to be constant and WACC is adjusted for the tax shields. It is WACC that assumes that the debt rebalancing needs to be done to keep it at a constant level.
FCF calculation does not require the debt part. It is Earnings Before Interest and Tax (EBIT), Tax, Depreciation, change in working capital and capital expenditure that are required for the FCF approach of valuing a firm. Therefore, FCF approach does not require debt rebalancing to arrive at the value of a project.
FCFs are unlevered in nature because they are free from debt instruments. The calculation of FCF is therefore unrelated to debt rebalancing. FCF approach therefore does not require debt rebalancing to estimate the project evaluation.
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