Omar Corp is currently at its target debt ratio, but next week its debt ratio will significantly increase after it is taken private in a LBO. Omar will then gradually repay its buyout debt and reach its target debt ratio again in 5 years. Corporate taxation is the only capital markets imperfection that is relevant to Omar's valuation.

In this scenario, valuing Omar as of today using the WACC method with its current (pre-LBO) capital structure weights will definitely overstate its true value.

Question

Omar Corp is currently at its target debt ratio, but next week its debt ratio will significantly increase after it is taken private in a LBO. Omar will then gradually repay its buyout debt and reach its target debt ratio again in 5 years. Corporate taxation is the only capital markets imperfection that is relevant to Omar's valuation.

In this scenario, valuing Omar as of today using the WACC method with its current (pre-LBO) capital structure weights will definitely overstate its true value.

BlackTom AI · Accepted Answer

The question describes a scenario where Omar Corp is at its target debt ratio, then goes through an LBO that significantly increases its debt ratio, followed by gradual repayment of the buyout debt over 5 years to reach the target ratio again. It also states that corporate taxation is the only capital markets imperfection relevant to Omar's valuation, and asks whether valuing Omar today using the WACC method with its current (pre-LBO) capital structure weights will definitely overstate its true value.

Option 1: True. The claim here is that using the current pre-LBO WACC to value Omar today will definitely overstate value because the capital structure is going to become riskier in the near term (due to the LBO) and then gradually deleverage. When the firm faces a temporary leverage spike, the WACC that reflects the current (lower) cost of equity relative to debt would underestimate the weighted average cost of capital during the high-leverage phase unless the WACC is updated to reflect the higher debt and the associated changes in the cost of equity and debt. The reasoning hinges on the fact that WACC is sensitive to capital structure, and a substantial near-term change in leverage increases financial risk and the cost of equity, potentially raising WACC. If one values with the current (lower) WACC, that can overstate firm value because future cash flows would be discounted at a rate that does not properly reflect the higher risk in the near term. However, the statement says “definitely overstate,” which assumes that the WACC will not adjust or that the effect is unmitigated. In a typical framework where the near-term leverage spike persists or is highly material and the valuation horizon captures that risk, using the pre-LBO WACC would produce an overstated value relative to a valuation that incorporates the elevated risk and changing capital structure. The word “definitely” imposes a strong certainty; real-world valuations would depend on the exact timing, duration of high leverage, tax effects, and horizon over which the WACC is applied. But given the problem’s setup—clear, significant near-term leverage increase and a return to target ratio within 5 years, with taxation as the only imperfection—the pre-LBO WACC would not accurately reflect the transitional risk, suggesting that using it would lead to an overstatement in value when the near-term increased risk and higher debt load are not captured. Therefore, the statement is plausible and aligns with theory that a static WACC based on pre-LBO structure may overstate value when near-term leverage is expected to rise markedly.

Option 2: False. If one argued that using the current pre-LBO WACC would not overstate value, one would need to claim that either the near-term debt increase does not affect discount rates, or that the cash flows themselves would adjust in a way that neutralizes the effect of higher leverage, or that the horizon of valuation somehow aligns with the levered risk profile without requiring a higher WACC. In practice, higher leverage increases financial risk, the cost of debt may rise, the cost of equity typically rises as well, and the WACC would generally increase if measured with market-implied costs reflecting the levered structure. Moreover, if the tax shield is the only capital market imperfection considered, the standard approach would still require updating WACC to reflect the new capital structure because the tax shield interacts with debt and affects after-tax cash flows and risk. The assertion that the current WACC remains appropriate despite a significant near-term change in leverage is inconsistent with the basic concept that WACC is a function of the capital structure and the risk of the cash flows. Therefore, claiming it would not overstate value is not supported by the described scenario. The setup explicitly indicates a substantial near-term deviation in leverage, which would necessitate revising the WACC for accurate valuation.

In summary, the reasoning for Option 1 hinges on the sensitivity of WACC to capital structure and the near-term spike in debt, which can lead to overvaluing when using a pre-LBO WACC. Conversely, Option 2 would require assumptions that negate the impact of higher leverage on discount rates, which contradicts standard corporate valuation principles under the stated conditions.

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