Discussion Issues and Derivations

  1. What is the cost of equity and capital of a private firm?
    Implicit in the use of beta as a measure of risk is the assumption that the marginal investor in equity is a well diversified investor. While this is a defensible assumption when analyzing publicly traded firms, it becomes much more difficult to sustain for private firms. The owner of a private firm generally has the bulk of his or her wealth invested in the business. Consequently, he or she cares about the total risk in the business rather than just the market risk.
    1. Assume that the business is run with the near-term objective of sale to a large publicly traded firm. In such a case, it is reasonable to use the market beta and cost of equity that comes from it.
    2. Add a premium to the cost of equity to reflect the higher risk created by the owner’s inability to diversify. (This may help explain the high returns that some venture capitalists demand on their equity investments in fledgling businesses)
    3. Adjust the beta to reflect total risk rather than market risk. This adjustment is a relatively simple one, since the R squared of the regression measures the proportion of the risk that is market risk.
    Total Beta = Market Beta / Correlation between stock and the market
    Both these inputs have to be obtained by looking at industry averages for the sector in which the private firm operates.
    This beta can be used to estimate the cost of equity.
    The cost of debt for a private firm can be obtained using synthetic ratings or by looking at the rate at which the firm has borrowed at recently.
    Finally, the weights for debt and equity can be obtained either by looking at industry averages or by using a target debt to capital ratio.
  • How do you value a private firm?
    Unlike the valuation of stock in a publicly traded firm, the valuation of a private firm presents significant challenges. In particular,
    1. The information available on private firms will be sketchier than the information available on publicly traded firms.
    2. Past financial statements, even when available, might not reflect the true earnings potential of the firm. Many private businesses understate earnings to reduce their tax liabilities, and the expenses at many private businesses often reflect the blurring of lines between private and business expenses.
    3. The owners of many private businesses, who are taxed on both the salary that they make and the dividends they take out of the business at the same rate, often do not try to distinguish between the two.
    None of these limitations, by themselves, creates an insurmountable problem. The limited availability of information does make the estimation of cash flows much more noisy, past financial statements might need to be restated to make them reflect the true earnings of the firm and a reasonable opportunity cost might have to be charged for the owner’s contribution to the business. Once the cash flows are estimated, however, the choice of a discount rate might be affected by the identity of the potential buyer of the business. If the potential buyer of the business is a publicly traded firm, the valuation should be done using the discount rates based upon market risk