Um.. are you trying to say that the Company in question is 100% funded by debt? As in there is no equity? Because that's like, not a thing.

Some clarification is necessary--does 100% debt mean they don't have revenues yet; or that they don't have any equity?

DCF is the correct approach, IMO. Discount rate would be the WACC, so I see where you can run into problems in that number with the cost of equity--but cost of debt should just be the interest rate paid on the debt.

Can you just make the cost of capital equal to the cost of debt (ignoring COE)? Is that allowed?

Is this homework or a real life problem?

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If you're not raising equity capital, why would you need to value the equity?

If you're at the company raising equity capital, have massively inflated revenue projections and profit margins, then apply some earnings or revenue multiple. Show an attractive IRR for this wildly inflated figure and negotiate down from there as needed.

If you're the one buying the equity, value it as close to zero as possible and negotiate up there as needed.

If you're not raising equity capital, why would you need to value the equity?

If you're at the company raising equity capital, have massively inflated revenue projections and profit margins, then apply some earnings or revenue multiple. Show an attractive IRR for this wildly inflated figure and negotiate down from there as needed.

If you're the one buying the equity, value it as close to zero as possible and negotiate up there as needed.

This too.

"My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

If you're not raising equity capital, why would you need to value the equity?

If you're at the company raising equity capital, have massively inflated revenue projections and profit margins, then apply some earnings or revenue multiple. Show an attractive IRR for this wildly inflated figure and negotiate down from there as needed.

If you're the one buying the equity, value it as close to zero as possible and negotiate up there as needed.

Not value the equity, but value the business as it is. Profit margins are high. IRR is quite attractive, but again -> IRR is calculated through the "basic" formula in Excel w/o assuming more or less riskier biz. +- even 2-3% in WACC will dramatically vary the model. I want it to be as much pithy and reasonable as it could be.

snipeee:

If you're not raising equity capital, why would you need to value the equity?

If you're at the company raising equity capital, have massively inflated revenue projections and profit margins, then apply some earnings or revenue multiple. Show an attractive IRR for this wildly inflated figure and negotiate down from there as needed.

If you're the one buying the equity, value it as close to zero as possible and negotiate up there as needed.

Not value the equity, but value the business as it is. Profit margins are high. IRR is quite attractive, but again -> IRR is calculated through the "basic" formula in Excel w/o assuming more or less riskier biz. +- even 2-3% in WACC will dramatically vary the model. I want it to be as much pithy and reasonable as it could be.

You realize the owners of the 'business' own it through equity, right?

More information is needed (see bonks' & Sandhurst's questions above) because DCF may not be the correct approach under a variety of circumstances. For instance, since we're talking about a start-up, are we expecting positive free cash flow in the short run? How certain is your terminal value? If you lack positive free cash flow in the near term or certainty about the terminal value (for any number of reasons), a residual income valuation is more appropriate than a DCF.

"My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

Basicly, this is real life situation. I have to value the possible business.
Why I'm a bit confused is that the whole business will be financed through the debt (without equity) with repayment (let's assume) in 10 year's term. Notable FCF is expected in 2-3 years, so repayment is quite observable.
Why is it a problem?, it requires too much CAPEX on initial stage and it is not easy to start & run if you don't have enough knowledge, connections and money to launch the idea. Thus risk should be more than just cost of debt.

Frankly speaking, if we are in Emerging markets and have cost of debt significantly less than cost of equity and in this case we don't have equity at all, WACC in DCF will be too low for the country's average businesses - > which will raise lot's of questions and unreasonably high financials. Maybe DCF isn't the right one here or as the point we should anyway add country RP?

Definitely,
you have an idea, drawings, important connections etc...but you don't have enough money (or money at all). But again you have the opportunity to arrange a credit line for e.g. 10 years X% financing.
... if I correctly understood your question. That's why you still own the business

snipeee:

Definitely,
you have an idea, drawings, important connections etc...but you don't have enough money (or money at all). But again you have the opportunity to arrange a credit line for e.g. 10 years X% financing.
... if I correctly understood your question. That's why you still own the business

Ok, once again: if you're getting a credit line, why do you need to value the equity? We're basically dealing with an imaginary number for the value of the business. You can put as much science you want behind the valuation, but then you will still only have a highly precise imaginary number.

Ok, once again: if you're getting a credit line, why do you need to value the equity? We're basically dealing with an imaginary number for the value of the business. You can put as much science you want behind the valuation, but then you will still only have a highly precise imaginary number.

Management is going to start the project. With high margins you will begin to repay debt almost imideately (e.g. from the next year), so in 5 years half of debt will be repaid. Thus, what will your business cost?! And what discount rate do we need to apply right now to get the appropriate estimate of all financials as well as the whole business?
To be honest, I don't understand why you mean that we can't value it or you mean only equity?! - yes, we won't have it at first in the raw. But every business has its value. How can we calculate this one? :)

And since the project is 100% debt, would say wacc for dcf can be just cost of debt for the npv. After all, management and owners (parent co) are taking no financial risk here, assuming liabilities tied only to the project itself etc.

Value of a business = equity, here.

From my perspective its the same...that's will be a new business. Isn't it a start-up?! I've checked wording before posting just not to mix it up.
But anyway, lets return to the case. If we mention DCF, what will be our WACC if it is only debt financed. I described my concerns above.
To remind: cost of debt is too small, should we adjust it for any other premiums or not? Maybe we should apply different wacc for each year? e.g. 1st year WACC is only debt, 2nd year WACC is Debt + portion of redeemed equity? What d'u think? It's crucial to indicate risks, especially country and default risks!!! even in cost of debt, but theoretically they should already be included in the interest rate...

Cant tell if trolling us all or just mentally challenged....

HFFBALLfan123:

Cant tell if trolling us all or just mentally challenged....

????

Could you just True Interest Cost (TIC) to discount your cash flows if you are doing this 100% on debt?

Cruncharoo:

Could you just True Interest Cost (TIC) to discount your cash flows if you are doing this 100% on debt?

thanx!

This sounds like Project Finance.

OP, and anyone else interested.. check out this presentation (Valuation starts on pp. 71.):
http://www.scribd.com/doc/123390638/Project-Financ...

I think this is a case of a language barrier (at least I hope so). Anyways, OP:

If this is going to be financed solely through debt, then the WACC will be the cost of the debt only, ignoring the equity portion of the equation (I think, based on the responses above this doesn't violate any "laws" of finance).

8th grade math aside, the cost of debt is the interest rate at which you can borrow money (less corporate taxes, but yours may differ if you're not in the US). You say several times that the interest rate on debt does not sufficiently reflect the risk involved in the project, but that doesn't make any sense because interest rates are a function of risk. If you can get what you perceive to be an unusually low interest rate, then more power to you. A lower discount rate will increase the project's NPV.

Don't worry about the cost of debt, it's somebody else's job to figure that out.

can we use different wacc for different years increasing equity portion?

I think I understand you. Are you saying that, as the business grows, it will become more valuable, and therefore it will evolve from being zero-equity (aka "worthless") to having some equity value?

If that's the case, then "increasing equity" is an incorrect term--we're talking about cash flows, which will not require an adjustment to WACC. I'll continue to press that this comes back to finance 101--When using DCF, the value of the company is the NPV of all future cash flows. The enhanced "value" you're discussing comes from increasing earnings in later periods (aka growing future cash flows in the NPV equation), not an increase in equity.

If we can agree on that, then it just becomes a question of calculating your estimated future cash flows, assigning a terminal value wherever you begin to think (or realize) that your numbers are all made up, and calculating NPV.

Maybe I'm missing something, but I hope other members can chime in about what to do here.

2-3x the revenue run rate

It's simple, your company is worthless.

not worthless, DCF APV it, then discout cash flow at sector cost of equity, done.

Valor is of no service, chance rules all, and the bravest often fall by the hands of cowards. - Tacitus

Dr. Nick Riviera: Hey, don't worry. You don't have to make up stories here. Save that for court!

Don't forget taxes!

Ha ? Startups are financed with equity, NOT debt ! Sometimes (as a bridge between two rounds of financing) can use convertible notes. No bank in the right mind will give a credit line to someone who hasn't gone through series A, B, and C equity rounds, which means they have established sales growth.

You need comparables, not DCF, to see how much comparables were valued once profitable based also on probability of successful exit.

Financier4Hire:

Ha ? Startups are financed with equity, NOT debt ! Sometimes (as a bridge between two rounds of financing) can use convertible notes. No bank in the right mind will give a credit line to someone who hasn't gone through series A, B, and C equity rounds, which means they have established sales growth.

You need comparables, not DCF, to see how much comparables were valued once profitable based also on probability of successful exit.

Not really true per-se, if you pay attention to how OP clarified. This sounds like a specific project, which would have equity "owners" in some capacity, but capital is exclusively provided through debt. If you consider it in say a Project Finance framework, it's not that difficult to conceive of an investment along these lines.

Say, one made by a natural resources corp in an emerging market, with some kind of idiosyncratic tax regime which makes debt finance far more attractive. In such a regulatory environment, you could conceivably get away with 100% ProjectCo equity held by NatRes Corp's "SubA," and debt financing provided by "SubB," playing with domiciles, corporate hierarchies, etc as necessary. You could even be involved with a local government entity, government-controlled corp, shady local holding company with ties to government officials, etc. A JV of this nature, or even handing over the equity as a payoff; which in this case is really just the "excess return" above the interest on the debt finance, which you can set at whatever is your required rate of return + margin of safety, etc.

Sheesh, everyone. Think outside the box. Corruption's a big money business.

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Sandhurst:

Ok, I gave you a bonus point.

You could also use a modified APV analysis.

Instead of using the cost of equity to discount "base case" future cash flows, use the cost of debt. Then you would also use the cost of debt to value the tax shield.

Since this is in emerging markets, separating those two could be important considering political risk of changing tax rates, ect based on where this is located. Could provide a lot more clarity based on the facts you provided.

Why not use free cash flows to equity [normal FCF less after-tax interest payments plus (less) proceeds (repayment) of debt]? Then discount those cash flows at cost of equity (instead of CAPM, just use whatever you required return is). Then add the principal of debt at day 0 to the fair value of equity (I'm assuming book value of debt equals fair value of debt at day 0 since whoever is lending the money is negotiating the interest rate) to get the value of the business (specifically the market value of invested capital for you valuation nerds).

The thing I struggle with is that the equity holders aren't putting and dollars for their equity so what are they getting a return on? I guess the specialized skills/knowledge (that other's don't have access to) are what the equity holders are putting in. Otherwise, the lenders would be able to do the same project without the equity holders and have the same risk but higher return.