reading 58, Practice problem #35: A private equity fund is estimating the value of a privately held company that is financed with both debt and equity, is generating positive revenues, and has negative EBITDA. The private equity fund is most likely able to estimate the company’s equity value using:
C) expected free cash flow to equity and cost of equity. I dismissed this answer because it did not seem probable to have positive FCFE given negative EBITDA and debt payments. Can anyone help me find the flaw in my logic? Anyone seen sth like this in the wild?
I get where you’re going, but with the same logic could you not also just expect EBITDA to not stay negative forever and value based on that?
I selected answer B) market value of its assets. Admittedly, it would be a difficult to asses mkt value of debt for this, but not necessarily less accurate than modeling future FCFE based entirely on assumptions. If nothing else one can assume banks will not take a haircut so mkt value of debt is book value.
What makes you think that the debt financing is through a bank? (Companies are allowed to issue bonds, I’m given to believe.)
Even if the debt financing were through a bank, how does the bank’s unwillingness to take a haircut establish the market value of the debt? (If you were buying a loan from a bank, would you offer to pay par value simply because the bank doesn’t want to take a haircut?)
Correct, however I suppose I am not set on the logic as to why FCFE is a better alternative to market value of assets, considering both would be based on assumptions, as you pointed out.
You are right of course, nowhere does it state in the question the debt is bank financed. In the end, even if the debt is financed through bond issue (for which arguably it could be comparably easier to obtain a market value), my thinking would be that a conservative approach to valuation in this case is to assume book value of debt in entirety needs to be repaid, given no alternative to derive market value.
In the end, I realise I am reading too much into the question, but as above, I am not sure how to connect the dots to why FCFE is the superior choice in this case.
You can’t use a multiple of earnings because earnings are negative.
You can’t use a multiple of EBITDA because EBITDA is negative.
You can’t use discounted projected EBITDA because EBITDA isn’t cash flow; you would have to adjust it for non-cash items.
You can’t use net assets unless you can estimate the market value of the liabilities. You’re looking for an accurate value, not a conservative one, so there’s no reason to assume that the market value of the debt equals the book value. Even if you did want a conservative value, it’s possible that the market value of the debt is higher than the book value (e.g., the debt might have a high coupon, having been issued when the company was very risky, and the YTM today might be much lower because the risk is lower).
Approaches that would make sense are:
Discounted FCFE
Discounted FCFF (if the market value of the liabilities is estimable)
