How to calculate EV and equity value via DCF with anticipated future debt issuance?
Situation is as follows:
- I am trying to value a stock and built a three-statement model for the next ten years to do a DCF.
- I determine unlevered free cash flows for every year in the modeled period and discount those back to the present. I do the same with the terminal value. I use operating cash flows minus capex for my FCF.
- With that, I arrive at an enterprise value. To get to equity value, I need to subtract net debt. The company in question has no debt but a sizeable cash position, so the equity value ends up higher than EV. For simplicity's sake, let's say my EV is $200m and equity value is $230m, implying cash of $30m and zero debt.
- So far, so good. Here is where my problem comes in: the company is growing and needs a lot of capital (significant growth capex). Without any new equity or debt, my three-statement model shows that in about 3-4 years, the company will run out of cash.
- Since running out of cash is suboptimal, I model a bond issuance in three years of $60m.
- My question is this: how does that affect my EV and equity value? At the exact moment of issuance, net debt doesn't change. Right? Since $60m in new debt less $60m in new cash is zero. But it seems weird that issuing new debt would not change my valuation? Where is the error in my thinking?
If it wasn't abundantly obvious already, I'm new at this. Thanks for any help.
No one?
Issuing debt and getting the corresponding cash should not result in a change to your valuation, since that transaction did not have any economic impact on shareholders.
Once you start paying interest expense or using that cash in either an accretive or dilutive manner, then it will have an impact.
but then company spends this cash in next 2-3 years and although usually net debt is just the current calc, maybe he can just increase the debt by 30m for illustrative purposes? on top of that, net effect from interest calcs & tax savings will add some of the negative effect.
Also, OP what makes you think the company will be able to raise debt for growth capex? Your worst case scenario should be to assume that company issues equity to raise that 60m, best case maybe assume no impact (maybe shareholders will think - this is great news! growth can accelerate and we're not diluted!).
doing this exercise to assume the market reaction seems very complicated. leading up to the capital raise, share price would probably fall because people weigh in chance of equity raise (see Card Factory UK), then as information clears out it would rise but possibly not to previous level
I'm assuming (but also clearly pointing out that it's an assumption) that the company will be able to raise the debt as there are very comparable debt financing transactions involving its direct competitors. It's a relatively new sector where most companies are constantly raising new money (both equity and debt) to finance growth so it's not exactly unexpected. The reason I'm going for (high yield) debt instead of equity has to do with the company's backlog (it's manufacturing related) and competitive positioning.
Appreciate your response, thank you. I think it made something click for me:
Does that sound right to you? Thanks again for your help.
Edit: Thanks to another response I got, I realized that I don't need to change my EV but I do need to adjust my equity value to account for the debt to plug the funding gap.
My initial thoughts would be:
Thank you, this was very helpful. Just to make sure I understand you correctly, if I follow your approach:
Yes, basically that. I'm saying that you use whatever method of valuation you choose (in this case dcf) to arrive at enterprise value. Then, the same way you add your net cash as of today or any other adjustment, you subtract the future capex debt financing requirement like a liability on the balance sheet today.
If you issue equity in the future, this is slightly more complex. I think subtracting it is fine for simplicity but also might be tempted to compare this to the equity value of the dcf on a per share basis and run a second method where instead of subtracting the equity issuance, you dilute shares for number of shares issued in future financing.
You could use the APV method which is used for companies with changing capital structures in your forecast, such as issuing debt.
the issue with the classic DCF WACC method is it assumes a constant capital structure in your discount rate. For a company with increasing Debt % throughout the forecast the EV will be higher because of the interest deduction of tax which lowers the overall WACC wherein
WACC = W_d * k_d * (1-t) + W_e * K_e
so weight of equity will lower and weight of debt will increase with a lower required return.
alternatively you could use a levered free cash flow to equity model which will capture the debt issuance. That’s what I would do. Tbh I’m not sure why you’re trying to build a 3 statement model using unlevered free cash flow? LBO models should always use levered free cash flow which capture debt service, issuance, retirement, etc. The only difference is you just give it a cost of equity to discount the cash flows to PV vs. trying to calculate an implied IRR.
but honestly no one in industry uses APV, only college professors because it’s overly complicated and doesn’t make much of a difference, see other comments below indicating it’s pointless as you should just focus on the return the assets require, regardless of financing.
Thanks for your input. The idea for using unlevered FCF was because there is so much uncertainty regarding this company's future capital structure. I mentioned this elsewhere but it's a capital-intensive manufacturing-related company in a sector where everyone is constantly raising funding to grow more or less as fast as they possibly can but they are currently only equity-financed.
And it's not an LBO model actually, not sure if that would change your answer?
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