challenging the discount rate brendan daw …€¦ · · 2015-02-16challenging the discount rate...

CHALLENGING THE DISCOUNT RATE BRENDAN DAW &

SIMON DALGARNO

© Leadenhall Corporate Advisory 2015

CHALLENGING THE DISCOUNT RATE

2 CHALLENGING THE DISCOUNT RATE



REWARD AND RISK

3

Is the reward worth the risk? How do we measure the trade-off?



It’s the present value of the future benefits

We discount future cash flows for :

The time value of money

The opportunity cost of an alternative investment

The specific risk of this investment achieving the expected

cash flows.

4

MEASURING THE RETURN



High

High

Low

Low

RET

UR

NS

RISK

PE Firms Biotech co. Returns of 30%-50%

AVH: 5~1070

Share Market Returns of 12%-14%

Property Returns of 6%-8% Risk free Asset

Returns of 2%-3%

RISK & RETURN TRADEOFF

5

A

B

Discount rate 12%

Discount rate 20%



COMMON USES

Project evaluation

Business case modelling

Decision making

Impairment testing

Business and asset valuation

Regulated pricing models

ROI calculations

6



COMMON ERRORS

Using the same rate we always use

Using word of mouth / rule of thumb / stab in the dark

Asking a colleague what they use

Not updating the rate to reflect current conditions

Lack of understanding

Incorrect application:

o nominal rate applied to real cash flows

o post tax rate applied to pre tax cash flows

o using cost of capital to pre interest cash flows (should use WACC)

Calculation error:

o Mis-calculating the components

o Not optimising the level of gearing when measuring WACC

7



EXAMPLE

Three cash flow profiles, each with an equivalent NPV of $5m at 12.5%

8

0

1,000

2,000

3,000

4,000

5,000

6,000

Yr 1

Yr 3

Yr 5

Yr 7

Yr 9

Yr 1

1

Yr 1

3

Yr 1

5

Yr 1

7

Yr 1

9

Yr 2

1

Yr 2

3

Yr 2

5

Yr 2

7

Yr 2

9

$'0

00

Hypothetical cash flows

High early growth then to CPI Constant Growth High hockey stick late growth

56,112

27,860

22,007



VALUE IMPACT OF DISCOUNTING

9



TYPES OF DISCOUNT RATES

Cost of equity (Ke)

o 100% equity funded projects

o Applies to after interest cash flows

Weighted Average Cost of Capital (WACC)

o Based on mix of debt (Kd) & equity (Ke) –at optimum level

o Applies to pre-interest cash flows

10



Ke = Rf + β (MRP) + OC

Rf- Risk free rate

β – Beta- sensitivity to the market

MRP – Market risk Premium

OC – Specific risks

o Size

o Forecasting risk

o Other- Eg… key person/client/competitor

11

AVH: 5~1000

COST OF EQUITY



WACC = weighted average cost of capital Ke = shareholders’ required rate of return (cost of equity) Kd = lenders’ required rate of return (cost of debt) t = the company’s tax rate E = market value of the equity of the company D = market value of the debt V = D + E.

12

WEIGHTED AVERAGE COST OF CAPITAL


13 CHALLENGING THE DISCOUNT RATE 13

OPTIMISING WACC



Factors that impact discount rates

Factor Impact on Discount Rates

Lower Higher

Industry Growth Expanding proven market Declining or new market

Business Growth Above industry norms Below Industry norms

Location and Facilities Above Average Below Average

Diversification of products and geographic markets Diverse products and multiple markets Limited product lines and markets

Competition Few competitors and/or high barriers to entry Highly competitive and/or unstable market.

Concentration of Revenue A large number of customers High Customer Concentration A few large customers account for 50% – 60% of revenue

Forward Orders High level of future revenue links to committed forward orders

Future revenue not underpinned by forward orders

Reorder patters Long term relationships, agreed contract renewals Customer has a high switching cost. Price is not primary factor in decision

Once off, “lumpy” or regular rebids in a competitive process Customer has a low switching cost. Customer is Price Sensitive

Contractual Relationship Long term stable customers Contracted (Price and volume) or Cost plus contract

Short history and or high churn Uncontracted or Fixed Price Contracts

Leadenhall Corporate Advisory Pty Ltd © 2013

ADDITIONAL CONSIDERATIONS

14



Factor Impact on Hurdle Rates

Lower Higher

Seasonality of revenue and/or of the clients revenue No seasonality Highly seasonal revenue

Future Growth opportunities Expansion will come from existing services in existing markets

Expansion is based on new server or new market.

Nature of Costs Higher proportion of variable overheads Higher proportion of fixed overheads

Stability and Skills of Employees Long term, well trained and motivated employees High turnover and/or unskilled employees

Business Systems Business process and service is highly systematised and requires littlie modification between clients

Business process or service is highly customised by client and / or assignment

Management involvement required Limited ongoing management time required Significant ongoing management time required

Stability of Historical Earnings Stable and above industry norms Marginal, erratic or less than 3 years good history or below industry norms

Working capital requirements and payment terms Little if any working capital requirement and /or agreed upfront payments and contractual progress payments.

High working capital requirement or progress payments not agreed in timing or amount.

Expected Demand for Capital Capex expected to be less than depreciation Significant Capex or guarantees required.

Counterparty Risk Government, large corporates and companies providing part payment up front or bank guarantees

Smaller companies or subsidiaries of large corporates and special purpose entities with no guarantee from parent

ADDITIONAL CONSIDERATIONS

15



Different levels of earnings will result in different valuation conclusions:

16

Before Interest

Cash Flows

After Interest

Cash Flows

Pre - Tax

Cash Flows Pre - Tax WACC Pre - Tax Ke

Post - Tax

Cash Flows Post – Tax WACC Post – Tax Ke

Result Enterprise Value Value of Equity

Equivalent multiple EBIT | EBITA | EBITDA P/E | Dividend Yield

DISCOUNT RATE


17 CHALLENGING THE DISCOUNT RATE 17

RECENT CHANGES IN WACC

8.8% 1.3%

0.4% 0.0% 0.2% 8.2%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

December 2013 Rf EMRP Gearing Credit spread December 2014

Movements in WACC



Guideline Public Company Method

From multiples derived from listed comparable companies.

Merger and Acquisition Method

From multiples derived from comparable transactions.

First Principals Method

From multiples calculate based on the Required Rate of Return of an investment.

18

ALTERNATIVES



• RSM Bird Cameron Business Acquisition and Impairment Review 2010

19

GUIDELINE PUBLIC COMPANY METHOD

RSM Bird Cameron Business Acquisition and Impairment Review 2010



Guideline Public Company Method RSM Bird Cameron Business Acquisition and Impairment Review 2010

20

For ASX 300 companies the discount rates noted were often within the range of 10% to 12% For non ASX 300 companies the discount rates noted were most often within the range of 12% to 14%

GUIDELINE PUBLIC COMPANY METHOD



Description

Category Business Status Industry

Competition Financing

Requirements Management

Depth Past Earnings Future

Earnings

Risk Premium* (Pre-tax)

Implied EBIT

Multiple **

1 Established business

Strong trade position

Well financed Depth in management

Stable Highly predictable

6–10% 9.1 x

2 Established business

More competitive

Well financed Depth in management

Stable Fairly predictable

11–15% 6.3 x

3 N/A Highly competitive

Little capital required

No depth in management

N/A As risk is high not very predictable

16–20% 4.8 x

4A Small, depends on special skills

N/A Little capital required

N/A N/A Very unpredictable

21–25% 3.8 x

4B Large, established, highly cyclical

N/A N/A May be depth in management

Past earnings may not be stable

Very unpredictable

23–25% 3.7 x

5 Small ‘one person’ business

N/A N/A Managed by main operator

N/A Extremely unpredictable

26–30% 3.3 x

AVH: 5~1730

* To be added to the risk-free rate Developed from an article by James H. Schilt and Hanan & Kiebier, Inc, Business Valuation News.

** Midpoint Assuming 6% Risk Free rate and 3% ongoing growth

RISK PREMIUM FOR BUSINESS

21



Rates of Return Required by Venture Capital Investors

22

(AICPA Equity Security Taskforce: - Practice aid on the Valuation of Privately Held Company Equity Securities Issued as Compensation, Para B.02)

Stage of Development Plummer1 Scherlis & Sahlman2 Sahlman, Stevenson and Bhide3

Startup4 50%-70% 50%-70% 50%-100%

Frist stage or “early

development”5

40%-60% 40%-60% 40%-60%

Second stage or “expansion”6 35%-50% 30%-50% 30%-40%

Bridge/Initial Public Offering

(IPO)7

25%-35% 20%-35% 20%-30%

1. James L. Plummer, QED Report on Venture Capital Financial Analysis (Pale Alto: QED Research, Inc., 1987).

2. Daniel R Scherlis and William A Sahlman, “A Method for Valuing High Risk, Long Term, Investments: The Venture Capital Method,” Harvard Business School Teaching Note 9-288-006 (Boston: Harvard Business School Publishing, 1989).

3. William A. Sahlman, Howard H. Stevenson, Amar V. Bhide, et al., “Financing Entrepreneurial Ventures,” Business Fundamental Series (Boston: Harvard business School Publishing 1998).

4. As described in the publications referenced in this table, startup-stage investments typically are made in enterprises that are less than a year old. The venture funding is to be used substantially for product development, prototype testing, and test marketing.

5. As described in the publications referenced in this table, early development-stage investments are made in enterprises that appear viable and for which further technical risk is deemed minimal, although commercial risk may be significant.

6. As described in the publications referenced in this table, enterprises in the expansion stage usually have shipped some product to consumers (including beta versions).

7. As described in the publications referenced in this table, bridge/IPO-stage financing covers such activities as pilot plant construction, production design, and production testing, as well as bridge financing in anticipation of a later IPO.

DISCOUNT RATE


BRENDAN DAW

Qualifications Bachelor of Commerce (Accountancy),

University of South Australia

Chartered Accountants Australia & New

Zealand

Graduate Diploma in Corporate Finance

Professional Certificates in Leadership and

Marketing

Chartered Accountant Business Valuation

Specialist

Professional Memberships Member of Chartered Accountants Australia &

New Zealand

Registered Tax Agent

Experience

Brendan joined Leadenhall in 2010 with over 20

years’ experience in private industry, the

accounting profession, and the public sector.

Brendan’s wide ranging expertise includes being

Principal of his own consulting firm, a Director and

CEO in several small businesses as well as over

10 years as a CFO/Financial Controller.

Brendan’s acumen spans developing and

implementing business plans, managing finances,

resources and IT systems, analysing information,

creating adaptive financial models and undertaking

complex business valuations. Plus he is highly

skilled in preparing conclusive financial reports,

providing expert opinions and advice to the SME

market.



SIMON DALGARNO

Qualifications Bachelor of Economics, University of Adelaide

Institute of Chartered Accountants in Australia

Graduate Diploma in Applied Finance &

Investment, FINSIA

Professional Memberships Fellow of the Institute of Chartered Accountants

in Australia

Fellow of the Financial Services Institute of

Australasia

Member of the International Association of

Consultants, Valuers and Analysts

Experience Simon has worked in the valuation industry for in

excess of sixteen years and has completed

numerous valuations for private and public

companies including:

businesses - from power stations and heavy

engineering to rubbish dumps and consulting

practices

intellectual property - brands, plant breeding

rights, databases and computer systems.

Simon regularly advises on Option Valuation

(AASB 2), Purchase Price Allocations (AASB 3)

and Impairment testing (AASB 136) in accordance

with the accounting standards.

He regularly conducts seminars on valuation

theory and practice for legal and accounting

professionals and is a major contributor to the

leading valuation text, Australian Valuation

Handbook.



ABOUT LEADENHALL CORPORATE ADVISORY

Valuation

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Technology and IP valuations

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Leadenhall has been established for 28 years and we specialises in business valuations and in mergers and acquisitions advice.




leadenhall.com.au

CONTACT

ADELAIDE

Level 1, 31 Franklin St

Adelaide SA 5000

Contact: Simon Dalgarno

[email protected]

T +61 8 8385 2207

M +61 416 003 737

Contact: Brendan Daw

[email protected]

T +61 8 8385 2222

M +61 434 223 508

SYDNEY

Level 11, 65 York St

Sydney NSW 2000

Contact: Richard Norris

[email protected]

T +61 2 8823 6224

M + 61 416 152 823

Contact: Dave Pearson

[email protected]

T + 61 2 9199 1103

M + 61 431 487 016

MELBOURNE

Level 9, 440 Collins St

Melbourne VIC 3000

Contact: Elena Saarbrucken

[email protected]

T +61 3 9607 1330

M +61 457 721 722


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challenging the discount rate brendan daw …€¦ · · 2015-02-16challenging the discount rate...

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