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What is meant by Debt Rebalancing?
Debt rebalancing is a process of rebalancing the debt while calculating the Weighted Average Cost of Capital (WACC). The concept of WACC is based on the assumption that WACC remains constant throughout the lifetime of a project. It also depends on the fact that debt proportionality remains the same over the course of years of a project.
As WACC remains constant throughout the lifetime of a project, the debt will go down each year according to WACC.
As WACC remains constant over the years, to keep the debt proportionality constant, debt has to be rebalanced to keep the WACC constant.
This change in debt in the beginning of every year in capital structure is known as debt rebalancing.
Why Do We Need Debt Rebalancing?
The project value changes every year depending on the outstanding debt value. In the case of a project, this change in project value means that the debt has to be rebalanced to adjust the debt proportionality to WACC. In fact, the project value has to be calculated every year to determine the amount of debt.
For example, the value of the project at the beginning of 1st year is the value of Free Cash Flows for 8 years for a project that is to last 8 years. The amount of debt value will go down with each passing year. However, the WACC or the project value cannot change. To keep the project value and WACC the same, the debt value has to be tweaked so that the values of debt in proportion to WACC remains the same. Hence, we need debt rebalancing.
How to Perform Debt Rebalancing?
The debt proportionality needs to be maintained along with WACC, and so the proportionality in percent terms is multiplied with the project value to get the amount of debt that has to be sourced each year.
If the proportionality value is 60%, we multiply this with the total debt outstanding at the beginning of each year.
As the debt value goes down, and proportionality value remains the same, we need to rebalance the debt part to get the constant WACC value.
In practice, there is no need to calculate the debt, interest tax shields and interest under the Free Cash Flow (FCF) way of project value estimation. This is so because the capital structure is assumed to be constant in FCFs. Only WACC has to be adjusted for interest and interest tax shields. Therefore, debt rebalancing is done automatically in such conditions. The concept of WACC actually assumes that the debt has to be rebalanced to keep the capital structure constant.
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