Valuation Exam 3 Questions and Answers

Valuation Exam 3 Questions and Answers matching discount rate and CFs -wacc is for expected cash flows -promised CFs need a higher discount rate b/c don't incl. risk -rf rate is for CFs from forward (market prices) why are PE hurdle rates so high? -very risky investments -PE firm provides expertise -hoped for CFs, not expected -opportunity costs -liquidity premium adjusted valuation process -focus on terminal value -CF insignificant in early periods -negotiate ownership stake -focus on investor's equity types of PE funding -seed/start-up -1st-stage capital -2nd-stage capital -expansion -bridge capital -mezz capital PE firm financial intermediary in business of raising pools of capital and investing it in co's that need financing private equity an ownership stake in private co/share of public co that're restricted so can't be sold for a time period seed capital/start-up capital -no product or service yet -no intermediary, friends and family, business angel investors -50-100% ROR -10 yr holding period early stage capital 1st, 2nd, successive-round VC financing venture capitalists carry co to point where they need access to public markets for financing/sold to other co's growth/expansion capital -profitable business but can't fund via earnings -can incl. consolidation financing and exit financing for founders -20-30% ROR -3-5yr holding period restructuring/reorg. capital vulture capital, LBOs 4 pieces to valuing a VC investment and structuring a deal 1. investor expectations 2. valuing equity 3. estimate EV at end of planned investment period 4. compute ownership interests (define deal structure) post-money investment value implied value of equity of firm today pre-money investment value value of firm's equity on the date of financing staged financing commitments VC makes staged investments as firm meets pre-determined milestones and as money is needed -VC has control over firm's access to capital -option to invest at another stage-- VC can offer lower rate of return -entrepreneur gives up less business but takes more risk debt or preferred stock PE financing issue debt/preferred stock -VC has less risk b/c have superior claim over common stock -entrepreneur takes on more risk -reduces financing need-- reduces equity stake taken by VC leveraged buyouts (LBOs) business acquisition where investor firm acquires all equity of firm and assumes its debt -50-80% of financing comes from debt bust-up LBO once control of acquiring co complete, new owner sells of some of firm's assets and uses proceeds to repay debt used to finance acquisition -want to incr. eff in operations build-up LBO create large public co from acquisition of initial co. followed by series of smaller add-on acquisitions -larger and more liquid than platform co. and individual add ons -combined firm may sell for higher multiple in public markets -combined co more diversified-- higher debt capacity-- higher multiple -debt of add-on co's guaranteed by platform co. multiples expansion add cheap assets of add-on firm to platform co. and sell for higher multiple of platform co. in future to add value limitation of PE valuation approach -estimate EBITDA at end of PP -est EV using EBITDA mult -find equity value -find IRR -doesn't explicitly account for risk associated w/ investment (maybe use APV for changing financial leverage) 5 drivers of value (PE) 1. yr 1 ebitda 2. ebitda growth rate 3. capex 4. ebitda mult. to est TV 5. unlevered cost of equity expected value indifferent b/t W-A exp return and certain return Xth percentile level of sales so there's only an X% chance actual sales are less than that level expected value maximum -if used, would exchange uncertain outcome for its exp. value -if probabilities of best outcome incr, exp. value incr. marginal gain amount you're willing to pay for info to get your exp. value of new -exp value of new - exp. value of old decision trees like forwards and options -decide -- learn outcome = forward -learn outcome -- decide = option waterfall way to distribute cash w/ cash already given to you ex-cash sweep all (or %) of excess cash used to pay down debt 1st before paying equity holders derivative securities approach to valuation 1. forecast future CFs 2. use market prices to est. certainty equivalents 3. discount CE's of CFs w/ rf rate financial derivatives securities whose value is derived from value of another security/asset options right, not obligation, to buy/sell an asset for specific price w/in specified time forwards/futures obligate holder to buy/sell an asset at certain time in future for certain price certainty-equivalent CF certain CF that has same value to recipient as unknown CF being evaluated 2 advantages of CE CFs 1. can be more accurate in est. than exp. value 2. can discount at rf rate forward price price set today at which market participants are willing to buy/sell commodity at future date -CE of uncertain prices realized in future -usually not = exp. future price financial options options traded in financial markets default option in debt contracts contractual option option that arises b/c of design of contract that defines terms of an investment tracking portfolio portfolio of traded securities that replicates real investment CFs 3 reasons tracking portfolio CFs can differ from investments 1. reliability of market prices for derivatives 2. omitted proj. risks 3. basis risk omitted proj risks sources of risk not captured in CFs of tracking portfolios liquidity of derivatives if illiquid, market prices may not be reliable est of CE prices -may not be able to hedge large exposure basis risk arises out of diffs in specific nature of assets underlying derivative contracts and assets underlying real investment being evaluated reasons for basis risk -diffs in product quality (derivative contract for exact commodity may not exist) -diffs in geographic location (delivery costs) -diffs in contract terms binomial option pricing model assume future prices follow binomial distribution risk-neutral probabilities hypothetical probabilities that make forward price = exp. price next year volatility and option value incr. volatility = incr. option value -b/c protected from downside risk -higher and lower prices have asymmetric effect on CFs -higher prices = higher revenues, losses w/ lower prices have floors w/ nonrecourse debt timing options possible to postpone implementation date of investment operating options can adjust operations to resp. to changes in environment real options to consider before investment launch -staged-investment option -timing options -operating options real options to consider after investment launch -growth options (-- strategic options) -shutdown options -abandonment options -switching options (inputs) -switching options (outputs) growth options opportunity to expand scale and scope of investment -scale: grow specific proj output w/ incr. vol of production -scope: follow-on projs strategic options justify investing in neg NPV projs but open door to future investments w/ pos NPV shutdown options shutdown in bad times and operate in good times switching options - outputs ability to vary output mix to reflect relative value from alternatives switching options - inputs ability to switch b/t 2+ inputs gives opportunity to minimize input costs value of option to delay comes from opportunity to learn more options and flexibility if option provides more flexibility = more valuable -good to have flexibility to choose options why are firms reluctant to wait on pos NPV investments? -can't perfectly hedge real options by selling financial ones so waiting is risky -investor may be credit constrained/face high borrowing costs -initiating proj. may give info to help eval future investments -show outside investors the firm has pos NPV investments -personal reasons volatility and npv hurdle incr. volatility -- incr. npv hurdle CF yield and option value incr. CF yield -- decr. option value limitations of V* model -int rates and volatilities are fixed over option life -payouts are fixed % of investment value -assume investment opp lasts forever/never expires 3 ways to value real options 1. binomial lattice approach 2. real option formula 3. simulation analysis futures must be exercised in time window, ETFs (standardized), mark-to-market, usually cash out forwards exercise on a date, OTC (custom contracts), usually take delivery and close out, no $ exchanges hands at beginning how does flexibility incr. value? comes from choosing alternative that enables downstream decisions pieces of options that create value incr. uncertainty (volatility), longer maturity, lower exercise price (for call) derivatives and CE forwards contracts are certainty equivalents law of one price synthetic and actual CFs match every year proj costs and synthetic costs if proj costs synthetic costs, invest in financial market -diff is NPV of proj black-scholes vs. binomial model black-scholes is always right IF valuing european options real options and hurdle rates -NOT the rate used to discount -proj can be delayed = higher hurdle rate -proj can be implemented in stages = lower hurdle rate -proj more liquid = lower hurdle rate -proj w/ "strategic value" = lower hurdle rates -higher hurdle rate = pickier w/ proj real option mistakes -using wrong volatility -assuming exercise price is fixed -overest. value of flexibility (source of option value comes from flexibility) -double-counting risk (in CFs and discount rate) -failure to understand how investment choices affect price volatility -forcing problem to fit in Black-Scholes -abusing real options analysis to justify "strategic investments" suppliers of PE investors -firms are mostly limited partnerships who raise capital from small # of investors first stage capital -proven product, need marketing and production -40-60% ROR -5-10yr holding period -VCs first entry point second stage capital -started production, not profitable -30-40% ROR -4-7 yr holding period bridge capital -ST loan while arranging funding -20-40% ROR -1-3 yr holding period mezzanine capital -b/t D&E holders -20-40% ROR -1-3 yr holding period optimistic DCF approach for optimistic CFs -bond valuation, VC, LBOs why does the investor need the option b/c the entrepreneur will want the money when things are going badly 2 ways to refine a deal structure 1. use staged investments 2. use debt or preferred stock analyzing decision making -criteria for determining good alt -uncertainty -early decisions affect later ones -value of info good decision action taken that's logically consistent w/ alternatives we perceive, info we have, and our preferences good outcome future state of the world that we prize relative to other possibilities do we reward good decisions or outcomes? good decisions -risk in decision trees means probabilities timing of decision trees -decide -- learn outcome = forwards -learn outcome -- decide = options 3 steps to valuing an option 1. est. value of underlying opp w/o option 2. est. value of opp w/ option 3. value of option is diff b/t value of opp w/ option and value of opp w/o v* value of underlying investment that triggers exercise of real option