Came across a technical question I've never seen the other day in an interview. Wanted to see what thoughts you guys have on the best way to have answered it:
- You have a company that is $100M in EBITDA and throws off $100M in FCF every year.
- This Company never grows or decreases, no matter what is done to it. It remains consistently year after year, $100M in EBITDA and throws off $100M in FCF.
- What would you pay for this company? How would you lever it?
It’s a perpetuity
Also interested
Interesting question. I'll share my thinking - hopefully someone will come behind me to correct and/or refine my approach.
First thing I'd ask about is the basic premise, where $100MM of EBITDA always yields $100MM of FCF... but you're asking me to play with leverage? In the real world, increasing leverage would keep EBITDA constant but reduce FCF. If I'm supposed to ignore this and just assume FCF of $100MM then this becomes very simple. Employ the maximum possible amount of leverage, and then value your FCF stream as a perpetuity (probably using the risk-free rate as the discount rate?).
If, on the other hand, we assume increased leverage reduces free cash flow, this gets pretty complicated pretty fast. Ultimately I think we want to maximize the Present value of the free cash flow (using WACC as discount rate) divided by our equity investment. Every time you increase leverage, you reduce the PV of FCF (higher interest payments, higher WACC), but you also reduce your equity investment, which helps offset the lower PV in terms of ROE.
Where I get lost is trying to justify an EV/EBITDA multiple for this hypothetical company with an undetermined capital structure, which would determine the amount of the equity investment required for a given level of leverage. Given this, I'd think it would be pretty easy to model a curve of ROE based on leverage and just pick out the maximum ROE.
Other thoughts?
We can't use an EV / EBITDA multiple for the reason you explained above and because there are no suitable comps, so the only way to determine the EV of the company is to do a DCF. We know EBITDA and FCF are both equal to $100M, so there are no interest payments, so there is no debt on the company. Then, you can calculate your EV based on the dividend perpetuity model up above--all you need is your cost of capital.
There is no difference between debt and equity here since the risk is exactly identical (i.e., no risk at all) no matter where you are in the capital structure, so cost of equity and cost of debt are the same. This means that the WACC = cost of equity = cost of debt always, no matter how much debt is on the company.
why would leverage reduce FCF? FCF is cash flow to both equity and debt holders do you mean FCFE? or can you elaborate please
Interest payments would reduce FCF but would not impact EBITDA. Since we're making an equity investment then the relevant metric is FCFE.
As someone mentioned, one way to look at it is as a perpetuity. The formula for a perpetuity is --> Present Value of Perpetuity = D / r [D = Dividend/Period & r= Discount Rate].
Assuming they have no debt already, the dividend is $100mm the discount rate should be the cost of equity, which should be pretty low. Assuming a 5% CoE you'd pay $2bn, assuming 6% CoE you'd pay $1.7bn, and assuming 7% CoE you'd pay $1.4bn.
Pretty interesting question since you are assuming the company doesn't pay any interest, taxes, capex, and/or little to no fluctuations in NWC. Assuming this company isn't going to disappear in the near future (since it's not investing in capex) you would use a ton of leverage since these CFs are guaranteed.
Tons of outstanding questions you could ask / assumptions you could make to get to an answer (more about thought process not your actual guess).
If EBITDA and FCF both equal $100M, then up front we know that the asset is unlevered, there is no tax exposure (could have an inifintely large tax asset that can't be sold or transferred), and the business has no assets or liabilities (or at least, no long-term PP&E, fixed level of NWC, no CapEx).
If it pays out in perpetuity and the cash payment is always fixed, then this is a riskless return. That means the ideal discount rate is as close to 0% as possible (i.e., this is even safer than Treasuries). However, in practice, investors all have different costs of capital that are separate from the theoretically ideal discount rate.
As a result, what you pay for this asset then depends on your cost of capital. Those with the lowest cost of capital will be willing to pay the most for it, using the perpetuity formula provided previously. Owners of the asset will continue to sell the asset to someone else (or lever it up with someone else's capital) until the asset is owned by the private equity fund / family office / endowment with the lowest cost of capital.
There is no point in thinking about leverage, since there is no tax shield created by the leverage (EBITDA and FCF both equal $100M, so we know there is no tax exposure) and there is no risk of default. As a result there is no strategic reason to use leverage here, so you could lever this asset as much or as little as you want, depending on your preference for being paid in the future (0% leverage) or being paid now (either 100% leverage or you could sell the asset).
Very interesting question!
It's a tax-exempt, zero growth perpetuity. It's value is $100/discount rate. There's no tax shield and thus no benefit to leverage.
Since the business is very consistent I would lever at 7x EBITDA or $700mm at a 5% cost of debt (debt will be cheap since the business is steady and generates a lot of cash). Interest expense will be $35mm and my levered FCF will be $65mm. Assuming I work in PE and want a 20% levered return, I will need to pay 5x levered FCF or $325mm, resulting in a total purchase price of $700mm + $325mm = $1,025mm or 10.25x EBITDA.
Without any debt the most I would be willing to pay to generate a 20% return is 5x $100mm or $500m which is clearly a lot less than $1,025mm, so in this case applying leverage helps me to obtain a much higher purchase price which will be viewed more favorably by the seller.
And you would be outbid by someone paying about 3.2 billion. Answers above are correct. Unless you have an idiot seller that doesn’t know what his asset is really worth.
The idea it’s safer than treasuries makes some sense but that wouldn’t be a large credit spread. It would be roughly worth what a 0 coupon treasury yields minus a handful of bps.
Correct discount rate would be about 3.1%
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