Question

In the context of recent research on the Weighted Average Cost of Capital (WACC), the Adjusted Present Value (APV) and the Flow-to-Equity (FTE), which of these methods would you use for the following companies (explain your choice).

a) A firm with uncertain growth rates for the next 10 years.

b) A start-up firm with no debt.

c) A start-up firm with debt.

d) A financially distressed firm that has excess levels of debt but significant accumulated tax credits.

Answer 1

(a) DCF valuation - WACC

The uncertain growth rates for the next 10 years can be incorporated within the explicit forecasting period with appropriate adjustments in Return on Invested Capital (ROIC).

Growth rate = Investment rate * ROIC

Each of the line items in the Income statement and Balance sheet can be forecasted separately for the explicit forecasting period.

(b) DCF Valuation - Flow-to-Equity method

The bulk of a young company’s value comes from growth assets, and not its existing assets. Once the cash flows have been estimated, a discount rate computed and the present value computed, we have estimated the value of the aggregate equity in the firm. If all equity claims in the firm are equivalent, as is the case with a publicly traded firm with one class of shares, we divide the value of equity proportionately among the claims to get the value per claim. With young firms, there are potential problems that we face in making this allocation judgment, arising from how equity is generally raised at these firms. First, the fact that equity is raised sequentially from private investors, as opposed to issuing shares in a public market, can result in non-standardized equity claims. In other words, the agreements with equity investors at a new round of financing can be very different from prior equity agreements. Second, there can be large differences across equity claims on cash flows and control rights, with some claimholders getting preferential rights over others. Finally, equity investors in each round of financing often demand and receive rights protecting their interests in subsequent financing and investment decisions taken by the firm. The net effect of these diverse equity claims is that allocating the value of equity across different claims requires us to value both the preferential cash flow and control claims and the protective rights built into some equity claims and not into others.

(c) DCF valuation - WACC

There are two key risk parameters for a firm that we need to estimate its cost of equity and debt.

Beta and cost of equity: Young companies are often held by either undiversified owners or by partially diversified venture capitalists. Consequently, it does not make sense to assume that the only risk that should be priced in is the market risk; the cost of equity has to incorporate some (in the case of venture capitalists) or maybe even all (for completely undiversified owners) of the firm specific risk.

An alternate process is built around the following steps:

1. Sector averages: While the company being valued may not be traded, there are generally other companies in the same business that have made it through the early stage 33 in the life cycle and are publicly traded. We would use the betas of these firms to arrive at an estimate of the market risk associated with being in this business. Generally, this will require taking an average of the regression betas across the publicly traded firms, and unlevering the beta to arrive at the beta of the business.

2. Adjust for diversification or its absence: As noted earlier, the owners of young businesses tend not to be diversified. In fact, the entire firm may be held by the founder, who, in turn, has all of his or her wealth tied up in that investment. To account for this absence of diversification, we will again draw on the publicly traded firm sample. The same regressions that yielded the market betas for these firms also provides an estimate of how much of the risk in these firms comes from the market (through the R-squared and correlation coefficients in the regressions). Dividing the market beta by the correlation of the publicly traded firms with the market gives us a scaled up version of beta (that we will term total beta) that captures all of the risk of being in a specific business, rather than just the market risk:

Thus, as firms move through the life cycle and attract larger and more diversified venture capitalists into the fold, they should see lower costs of equity. Ultimately, the cost of equity will converge on the market beta measure, if the firm goes public or is sold to a publicly traded entity.

3. Consider the use of debt and its cost: Synthetic bond ratings can be estimated for any firm based upon financial ratios that are available even for private businesses. Thus, an interest coverage ratio can be computed for a small business and used to come up with a synthetic rating and a pre-tax cost of debt (by adding the default spread based upon the rating to the riskfree rate).

(d) APV method

In case of a financially distressed firm with high input tax credits, the firm is expected to have much lower tax liability and consequently, higher net income in the upcoming years which will be used to repay some part of the existing debt.

This will lead to changing debt-to-equity ratio. APV is often used when a firm's capital structure is expected to change significantly over the investment horizon, as you can more easily value interest tax shields this way. WACC is a discount rate used as part of a DCF valuation when capital structure is expected to remain relatively stable.