Help on valuation
Hi guys,
Need some help on a valuation scenario. We are looking to acquire an asset.
I’ve run a DCF based on FCFF to arrive at the EV, using a WACC of 11%. Valuation comes out to say, $50m.
I run another scenario to calculate IRR, using the same operating assumptions. Purchase price equivalent of $50m EV (say $10m after adj for net debt etc).
Here’s the issue: when calculating my IRR, it’s only 1-2%, as the asset is heavily levered. With the interest expense, it kills my returns.
Problem is- I don’t know how to reconcile the 2 scenarios or explain it in a non technical manner. My valuation of the company is $50m with a WACC of 11%. Why does my entry price of $50m then result in such a low IRR?
If the cash flows are above 1mm then you should have a positive IRR above 1%. A mistake you may have made here is that you’re including debt in your IRR calculation (for initial capital). It’s important to only calculate your equity at the beginning and the end.
Let’s say levered FCF is 5mm each year with a 5x FCF exit multiple and it’s 50% debt. Over 5 years you should have a 2x MOIC and then a ~15% IRR.
Not sure if this helped but good luck
I believe my calcs are correct as I only use equity value when calculating IRR.
To summarise:
The question put to me is this: If my valuation is $50m, shouldn't my IRR be closer to the discount rate of 11% (instead of 1%)? If my IRR is correct, shouldn't my valuation of the company be lower instead of $50m?
How can I explain this concept better in a non-technical manner to "older folk"?
A mistake you may have made is in what you do with the cash. Are you sweeping, or accumulating?
Remember DCF requires a constant target capital structure, so if you're not relevering annually to your target capital structure and paying out dividends, your LBO IRR will be below your cost of equity, all else held equal.
Cash is minimal, due to the high interest expense. Therefore, it does not move the needle when its paid out as dividends or accumulates till exit.
I hear you on the capital structure.
Please help me explain this in layman terms, to someone who lacks corporate finance knowledge.
Perhaps the value of debt at current (PV of debt, or the 40m you mention) is not right and should be higher. Consequently, the lower PV of Equity/pp yields a higher IRR, c.p. when exiting and squares with the EV from DCFF; assuming the debt calculations thought the period and at exit still hold. Seems to me (the only) logical explanation based on the points already mentioned above.
Let us know if you find out what's missing!
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