What discount rate would you use for a highly leveraged company?
A core Valuation interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
WACC, but it shifts as leverage changes. High debt lowers WACC initially (cheap after-tax debt) but raises financial risk — cost of equity rises (higher levered beta via Hamada), and beyond optimal leverage, distress costs raise both. For an LBO, model the changing capital structure year by year, or use APV (unlevered value + tax shield value) which handles changing leverage cleanly.
WHAT INTERVIEWERS LISTEN FOR
- ✓WACC changes with leverage
- ✓Cost of equity rises with debt
- ✓Hamada equation for levered beta
- ✓APV for changing capital structure
- ✓Financial distress costs
COMMON MISTAKES
- ✗Using a single fixed WACC
- ✗Ignoring tax shield benefits
- ✗Assuming cost of equity constant
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