Calculating WACC for Private Company with 100% Equity

Follow-up question for you if you're still around ...

What would you do with a private company that has a small amount of debt, but their equity is relatively meaningless. That is to say, the only equity is scraped out from ownership distributions. To simplify:

Assets: Current Cash: $2,000,000 Debt Cash: $1,000,000

Liabilities: Current Debt: $2,000,000 + Equity: Credit Retained: Earnings: $1,000,000 Debit Ownership: Distributions $950,000

I know the WACC formula and understand the how to get the right Beta ... but when I am calculating the (E/(E+D)) or (D/(E+D)) part of the formula what am I supposed to do? I have read several times to use the market value of debt and equity; however, I am not sure how that applies here. What do I do to get the right equity number? Ownership distributions could be anything.

Interested in this as well

There's always a comparable company. You're just not looking hard enough.

I'm assuming this interview was for an SA role? Many ways to answer this. You'd want to ask clarifying questions or make some assumptions. If you can garner that the business has different revenue segments, a simple answer would be to break down the company into segments and get comps for each one.

Going from first principles, I'd approach it as follows:

• the 'unknown' is the company's beta
• beta represents correlation of a company's equity return to market return from a systematic perspective
• assuming I could get sufficient years of the company's returns through the cycle, I'd check correlation of NPAT (as a proxy for stock returns, normalised for abnormal events to crudely eliminate nonsystematic events) against returns on the S&P500 (as a proxy for market return) to get a levered beta, then I'd unlever it
• if the company was listed, stock return data is available and I'd just run the correlation between those and returns on the S&P500 instead
• if I had a lot of time, I'd double check that unlevered beta against the betas of companies which should similar correlations (R^2) to the S&P500

Once I have an unlevered beta from that process, I can relever it for the proposed capital structure.

The only 'unknown' then remaining is the estimated cost of debt. For that, I can just take my cash flow forecasts, industry outlook and qualitative analysis on competitive position and talk with my bank's ratings desk, who will tell me where they think it would rate (say, B1/B). I'd then take a look at the latest DCM newsletter issued by my DCM team, or talk to the DCM team itself, to get an estimate of the spread that a credit of that rating, industry, EBITDA size, competitive position etc would have to pay.

Or else I'd just check what the actual cost of debt is for the existing company (assuming my valuation is for a deal which won't involve a change in capital structure and new debt, which is often not the case).

All the other WACC inputs - proportions of debt and equity funding, market risk premium, risk free rate, tax rate - are knowns.

If this is a mature company in a mature industry, I could also use the assumption that WACC = RONIC and look at what RONIC the company has achieved in the last few years. From distant and possibly incorrect memories of my MFin, that's based on the assumption that, in the long run, supernormal profits aren't possible. I don't think that's a safe assumption for a realistic DCF.

HOWEVER, in practice, what you do on an advisory gig is:

• work out what WACC inputs are known
• create a data table showing the resulting NPV calculation under a range of the unknown inputs
• put that table in front of your MD and say "OK, this valuation will maximise our fee on the deal, but I think this valuation is more defensible. Where do you want to the valuation to be?"
• MD tells you what end valuation he wants
• You go back and find whatever data you need to in order to justify the assumptions that produce the valuation your MD wants

use book value or PF equity. this is standard practice.

Book value of equity.

start by looking at the growth profile and relative size of the company. The higher the growth projections and smaller the revenue base, the higher the WACC should be, ceteris paribus. Growth / VC stage companies can be in the 20s - 40s or even beyond for early stage deals, while more mature companies are usually 20%. Besides growth and size, look at the volatility of past financial performance. The more volatile the revenue / earnings historically, the higher the cost of capital will be for the company. Think of it from an investors point of view... the less the likelihood of the company meeting their financial projections, the higher the cost of capital... so high growth / volatile and unproven businesses with little to no track record will require higher returns by investors to compensate them for the additional risk.

Also, if the company is mature, obviously the more debt they have (up to a reasonable leverage ratio) the lower the WACC generally. Wouldn't necessarily be true if the company was performing poorly and breaching covenants though, so watch out for that.

hope this helps.

All things being equal.

For a public co beta is easily available. Not so for a private co. Also, you might have to lever beta depending upon the capital structure of your private company viz-a-viz the beta of a comparable public co ( which you may use )

Basically, break wacc up into each of its components and come up with an estimate or range of each item - always have reasons for each estimate

What should the cost of debt be What should the equity risk premium be etc..

Now, as a general thought, the valuation of a private co will be around 20% discounted to the value if it were a public co. ( Liquidity discount )

Also, the kind of assets will influence this discount %. High quality/ very liquid assets will result in a lower % and vice versa

Thanks.

For the "risk premium" part of the CAPM, instead of mentioning the S&P500, should I instead suggest using a "gym industry premium" based on the excess returns of the gym industry over the risk-free rate?

I know no such gym industry index exists, but I thought it might be a good answer to let the interviewer know I understand the concept.

Any advice?

no you idiot

The risk is captured by beta. The difference between the market and the risk free rate will be the same. You could also add a separate risk premium but don't change the (Rm -Rf) part.

its the cost of capital

its the cost of capital

I was asked a similar question - about valuing a Squash court! I was asked to estimate beta, cost of debt etc and give the interviewer a number.

i would incorporate the obesity rate into the premium

Use target gearing to calculate your relevered beta and also the WACC.

From the ghetto....

I was taught to use the optimal debt ratio (as indicated by the industry norm). You don't want the value of the target to be drastically altered by your capital structure decisions.

why would you use the median and not the average

The median stops any outliers from affecting your data.

yeah...since you have no debt...unlevered and relevered betas should be the same.

Yep..WACC would be equal to Re.

Buyside CFA makes an interesting point...not sure though...since your firm is, at the end of the day, debt free....why would you want to use any debt in your assumptions...? I think you're on the right track....

Anyone else care to add?

Did you ever get an answer to this? I have a different but related question.