Question

If a company follows a constant debt policy, instead of a constant debt-to-equity
policy, using the WACC method in evaluating the company’s asset value would return
the wrong result. Is this true? Why?

Answer 1

The statement is true as constant debt equity ratio means that debt and equity both change by the same ratio and finally keep the debt equity ratio constant. But in case of constant debt, debt equity ratio would not remain constant rather debt will be a constant value. In case of WACC computation, we need Debt Equity ratio and we assume debt equity ratio to remain constant. This is true for constant debt to equity ratio but does not hold true for constant debt in which debt equity ratio would keep changing. Hence, WACC will not be correct if calculated based on constant debt equity ratio.