Cost of capital of private firms
Sunday, 14 November 2010
A knowledgeable teacher of finance told this writer to consider 10% as cost of capital while facing a dilemma or difficulty. Clearly it is a naive but handsome method. But this rule can not be applied all the time whether one is a theorist or a practitioner. A strong base is required. There is a certain theory regarding the calculation of cost of capital of a public limited company and, in reality, it is mostly practised as well. What is the concern here about a private firm? Or that of a firm which is expecting to enter into the business world?
Cost of capital or discount rate matters a lot when one is going to valuate a private firm. To this writer it is as significant as cash flows estimation. But there are certain processes and criteria to find out the cost of capital of a private firm as well. The base is very important because if one's cost of capital is supported by logic, then it is a valid one. This writer has taken help from internet and an article from the Stern business School to help address this issue. At the same time, real-life experience that was gained has been used while making business plans.
To value a private firm we need to discount the expected cash flows by an appropriate discount rate, i.e. cost of capital. As the formula is quiet similar to the one of valuating public firms, the difference lies only in finding the inputs. Cost of capital is one of the very important inputs.
If we need to value equity, we discount cashflows to equity at the cost of equity. And if we choose to value the firm, we discount cashflows at the cost of capital.
While finding the required rate of return under CAPM method, beta is a very significant input to be estimated. The standard process of estimating the beta in the capital asset pricing model involves running a regression of stock returns against market returns. In the absence of price information, as is the case with private firms, there are three ways in which we can estimate betas: Accounting Betas, fundamental betas and bottom up betas.
While price information is not available for private firms, for finding accounting betas we need to regress changes in a private firm's accounting earnings against changes in earnings for an equity index (such as the Dhaka Stock Exchange or DSE All Share Price Index). [Earnings Private firm = a + b Earnings DSI Index]
The slope of the regression (b) is the accounting beta for the firm. If we use operating earnings, this would result in an unlevered beta, whereas using net income would result in a levered or equity beta.
There are two significant limitations with this approach. The first is that private firms usually measure earnings only once a year, leading to regressions with few observations and limited statistical power. The second is that earnings are often smoothed out and subject to accounting judgments, leading to mismeasurement of accounting betas.
The formula of finding Fundamental Betas would be = 0.6507 + 0.25 CVOI + 0.09 Debt/Equity + 0.54 growth - 0.000009; Total Assets R2=18%,where CVOI = Coefficient of Variation in Operating Income= Standard Deviation in Operating Income/ Average Operating Income, D
We could measure each of these variables for a private firm and use these to estimate the beta for the firm.
Bottom-up Betas: We can estimate bottom-up betas for private firms and these betas have the same advantages that they do for publicly traded firms
Assume that the private firm's market leverage will look like the average for the industry. If this is the case, the levered beta for the private firm can be written as: ß private firm = ß unlevered (1 + (1 - tax rate) (Industry Average Debt/Equity)).
To get from the cost of equity to the cost of capital, we need two additional inputs - the cost of debt, which measures the rate at which firms can borrow, and the debt ratio that determines the weights in the cost of capital computation. If the private firm has borrowed money recently (in the last few weeks or months), we can use the interest rate on the borrowing as a cost of debt. If the private firm is being valued for an initial public offering, we can assume that the cost of debt for the private firm will move towards the average cost of debt for the industry to which the firm belongs.
In estimating levered betas, the industry-average or target debt ratios could be used in the computation. Consistency demands that we use the same debt ratio for computing the cost of capital. Thus, if the industry-average debt to equity ratio is used to estimate the levered beta, the industry-average debt to capital ratio should be used to estimate the cost of capital. If the target debt to equity ratio is used for the levered beta computation, the target debt to capital ratio should be used in the cost of capital calculation.
The writer is a management trainee, IIDFC, Structured Finance and can be reached at e-mail: javed@iidfc.com
Cost of capital or discount rate matters a lot when one is going to valuate a private firm. To this writer it is as significant as cash flows estimation. But there are certain processes and criteria to find out the cost of capital of a private firm as well. The base is very important because if one's cost of capital is supported by logic, then it is a valid one. This writer has taken help from internet and an article from the Stern business School to help address this issue. At the same time, real-life experience that was gained has been used while making business plans.
To value a private firm we need to discount the expected cash flows by an appropriate discount rate, i.e. cost of capital. As the formula is quiet similar to the one of valuating public firms, the difference lies only in finding the inputs. Cost of capital is one of the very important inputs.
If we need to value equity, we discount cashflows to equity at the cost of equity. And if we choose to value the firm, we discount cashflows at the cost of capital.
While finding the required rate of return under CAPM method, beta is a very significant input to be estimated. The standard process of estimating the beta in the capital asset pricing model involves running a regression of stock returns against market returns. In the absence of price information, as is the case with private firms, there are three ways in which we can estimate betas: Accounting Betas, fundamental betas and bottom up betas.
While price information is not available for private firms, for finding accounting betas we need to regress changes in a private firm's accounting earnings against changes in earnings for an equity index (such as the Dhaka Stock Exchange or DSE All Share Price Index). [Earnings Private firm = a + b Earnings DSI Index]
The slope of the regression (b) is the accounting beta for the firm. If we use operating earnings, this would result in an unlevered beta, whereas using net income would result in a levered or equity beta.
There are two significant limitations with this approach. The first is that private firms usually measure earnings only once a year, leading to regressions with few observations and limited statistical power. The second is that earnings are often smoothed out and subject to accounting judgments, leading to mismeasurement of accounting betas.
The formula of finding Fundamental Betas would be = 0.6507 + 0.25 CVOI + 0.09 Debt/Equity + 0.54 growth - 0.000009; Total Assets R2=18%,where CVOI = Coefficient of Variation in Operating Income= Standard Deviation in Operating Income/ Average Operating Income, D
We could measure each of these variables for a private firm and use these to estimate the beta for the firm.
Bottom-up Betas: We can estimate bottom-up betas for private firms and these betas have the same advantages that they do for publicly traded firms
Assume that the private firm's market leverage will look like the average for the industry. If this is the case, the levered beta for the private firm can be written as: ß private firm = ß unlevered (1 + (1 - tax rate) (Industry Average Debt/Equity)).
To get from the cost of equity to the cost of capital, we need two additional inputs - the cost of debt, which measures the rate at which firms can borrow, and the debt ratio that determines the weights in the cost of capital computation. If the private firm has borrowed money recently (in the last few weeks or months), we can use the interest rate on the borrowing as a cost of debt. If the private firm is being valued for an initial public offering, we can assume that the cost of debt for the private firm will move towards the average cost of debt for the industry to which the firm belongs.
In estimating levered betas, the industry-average or target debt ratios could be used in the computation. Consistency demands that we use the same debt ratio for computing the cost of capital. Thus, if the industry-average debt to equity ratio is used to estimate the levered beta, the industry-average debt to capital ratio should be used to estimate the cost of capital. If the target debt to equity ratio is used for the levered beta computation, the target debt to capital ratio should be used in the cost of capital calculation.
The writer is a management trainee, IIDFC, Structured Finance and can be reached at e-mail: javed@iidfc.com