D/E Ratio

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brazilatz

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When using the D/E ratio to lever up an unlevered beta, do you use total debt/equity, or net deb/equity?
 
I think it is total, IIRC. The cash drags on the equity return, so more of it should reduce the way leverage magnifies risk and return.
That would mean having a larger denominator.
 
This gets religious in a hurry – quick answer, you’re fine doing it either way as long as you document your assumptions. (even better: do it both ways, show the range of results)
Why it gets religious: you can only net out “surplus” cash, not all of it. But no one agrees what is truly surplus – firms claim they need it for rainy day, or to support future acquisitions, to bolster credit strength, etc. It almost certainly has value beyond other types of wasting assets (e.g. all of the Picasso’s sitting in the corporate safe).
 
Watchu takin’ bout, Darien! Those Prikassos are a hege against inflation!
;-)
 
I would say Debt. Not net debt.
In my book, D/E is just about your capital structure, i.e. right side of BS.
But I guess Net debt is also defendable.
 
it is a matter of preference as long as you remember to match cash flows with discount rates, as usual. you cant go wrong if you remember your valuation balance sheet and apply it consistently:
1) Cash + Operating Assets* = Equity + Debt
*Operating Assets = Tangibles + Intangibles (On- and Off-balance sheet) + Debt-Free Cash-Free Working Capital
When applying a DCF, this corresponds to FCFF discounted at the WACC. The right hand side clearly implies that WACC is weighted average of the cost of debt and cost of equity, where i would use total debt in all calculations.
The left hand side implies that you should include interest income in your FCFF, which is often overlooked because people don’t bother projecting a full income statement + balance sheet + cash flow statement. Growing cash balance can result in significant interest income in certain cases.
2) You can certainly rewrite the valuation balance sheet as
Operating Assets = Equity + Debt - Cash
Then in my DCF i would use FCFF excluding interest income, and the WACC should be a weighted average of cost of debt, cost of equity, yield on cash with a negative weight applied to the cash piece because of the minus sign.
If you make the simplifying assumption that cost of debt = yield on cash, you can use the same WACC as in 1) with total debt replaced by net debt in all calculations.
If you make the simplifying assumption that yield on cash = 0 (corresponding to interest income of zero in 1), you can use the same WACC as in 1) with no changes.
 
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