Financial Analysis: Debt-to-Equity Ratio

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Questions and Answers

What is the primary purpose of valuation in the context of estate tax and divorce court?

To estimate the cost of equity in a private transaction

To determine the offering price in an initial public offering (IPO)

To value a division or divisions of a publicly traded firm

To determine the value of a business for legal purposes (correct)

What is a key consideration in private to private transactions that can affect the discount rate?

Diversification of the buyer

Liquidity of the investment

Key person value

All of the above (correct)

What is the correct beta to use in estimating the cost of equity for a private business?

A beta of 1, since the private business is not diversified

The beta of a publicly traded company in the same industry

A beta of 0, since the private business is not publicly traded

A beta adjusted for the lack of diversification of the private business (correct)

What is the purpose of a sum-of-the-parts valuation?

To determine the value of a division or divisions of a publicly traded firm Signup and view all the answers

What is the concept of 'illiquidity discount' related to?

The investment's lack of liquidity Signup and view all the answers

What is the primary purpose of estimating the levered beta when valuing a private business?

To compute the weighted average cost of capital (WACC) Signup and view all the answers

What is the correct approach to estimating the cost of equity for a private business?

Use a beta adjusted for the lack of diversification of the private business Signup and view all the answers

What is the concept of 'key person value' related to?

The value of the current owner's presence in a private business Signup and view all the answers

What is the market value of equity of Abel Stores if the typical apparel store company trades at three times book value of equity?

$1.8 billion Signup and view all the answers

What is the debt to equity ratio that you will use to compute the beta for Abel Stores?

1:1 Signup and view all the answers

What is the adjusted after-tax operating income for Abel Stores, considering the owner's salary?

$350,000 Signup and view all the answers

What is the main reason for applying a smaller liquidity discount to Abel Stores?

The company has more revenues than the typical firm Signup and view all the answers

What is the purpose of the key person discount in private business valuation?

To reflect the expected loss in cash flows due to a key person leaving Signup and view all the answers

What action would you take to reduce the key person discount in a private business?

Hire more employees to replace the key person Signup and view all the answers

What is the purpose of adjusting the operating income for the owner's salary?

To reflect the true economic performance of the company Signup and view all the answers

What is the effect of a higher debt to equity ratio on the beta of a company?

It increases the beta Signup and view all the answers

What is the operating profit of Angko Restaurant in the most recent year?

$480,000 Signup and view all the answers

What is the debt-to-capital ratio of Angko Restaurant?

45% Signup and view all the answers

What is the expected growth rate of revenue for the next 5 years?

10% Signup and view all the answers

What is the beta of publicly traded restaurants?

1.25 Signup and view all the answers

What is the current return on capital (ROC) of Angko Restaurant?

20% Signup and view all the answers

What is the yearly interest payment on the outstanding debt?

$65,000 Signup and view all the answers

What is the reinvestment rate of Angko Restaurant from year 4 to year 5?

30% Signup and view all the answers

What is the treasury note rate?

4.25% Signup and view all the answers

What is the primary issue with estimating debt ratios in private company valuation?

Market values of debt and equity are not available for private companies Signup and view all the answers

Why is it difficult to estimate beta for a private company?

Market price based risk measures are not available for private companies Signup and view all the answers

What is the primary issue with cash flow estimation in private company valuation?

All of the above Signup and view all the answers

What is the purpose of a 'show' valuation in private company valuation?

To satisfy curiosity about the company's worth Signup and view all the answers

How do private companies' accounting standards differ from public companies?

Private companies use different accounting standards than public companies Signup and view all the answers

What is the consequence of not having market values in private company valuation?

The cost of capital cannot be estimated Signup and view all the answers

What is the challenge in separating 'salaries' from 'dividends' in private company valuation?

Both end up with the owner, making it difficult to distinguish Signup and view all the answers

What is the purpose of computing a present value in private company valuation?

To value the entire business or the equity in the business Signup and view all the answers

What is the gross profit margin of Angko Restaurant based on the income statement of last year?

64.17% Signup and view all the answers

What is the cost of sales as a percentage of revenue based on the assumptions provided?

35% Signup and view all the answers

If the pre-tax cost of debt is 7%, what is the after-tax cost of debt assuming a 30% tax rate?

4.9% Signup and view all the answers

What is the formula for calculating the free cash flow to firm (FCFF) for Angko Restaurant?

EBIT x (1 - tax rate) + Depreciation - Capital Expenditure - Change in Working Capital Signup and view all the answers

What is the terminal value formula used in the valuation of Angko Restaurant?

FCFF yr5 x (1+g)/(WACC-g) Signup and view all the answers

What is the key difference between the current scenario and the previous scenario?

The seller of the business is not diversified but the buyer is (or at least the investors in the buyer are). Signup and view all the answers

What is the total discount rate used in the valuation of Angko Restaurant, taking into account 20% key person risk and 15% illiquidity risk?

WACC + 35% Signup and view all the answers

What is the weight of equity in the capital structure of Angko Restaurant that is used to calculate the WACC?

100% Signup and view all the answers

Study Notes

Private Company Valuation

There are several reasons to value a private company, including:
- "Show" valuations (e.g., curiosity, estate tax, or divorce court)
- Transaction valuations (e.g., sale or prospective sale to another individual or private entity, sale to a publicly traded firm, or IPO)
- Valuing a division or divisions of a publicly traded firm (e.g., spin-off, sale to another entity, or sum-of-the-parts valuation)

Key Issues in Private-to-Private Transactions

Neither the buyer nor the seller is diversified, which affects risk and return models
The investment is illiquid, requiring an "illiquidity discount" to estimate the value of the business
Key person value: the business's value reflects the owner's presence and potential

Beta Estimation for Private Companies

The beta for publicly traded companies in the same industry can be used as a starting point
However, the beta may need to be adjusted for the private company's specific characteristics and risks
The average R-squared from the beta regression across the industry can be used to estimate the beta for the private company

Debt-to-Equity Ratio and Beta Estimation

The debt-to-equity ratio can be estimated based on the book value of equity and debt
The market value of debt can be assumed to be equal to the book value of debt
The beta can be estimated using the debt-to-equity ratio and the beta of publicly traded companies in the same industry

Adjusted Operating Income

The owner's salary may not be reflected in the income statement, and should be added back to estimate the adjusted operating income
The tax rate can be used to estimate the adjusted operating income after taxes

Discounted Cash Flow (DCF) Valuation

The DCF valuation method can be used to estimate the value of a private company
The cost of equity and debt can be estimated using the CAPM and the pre-tax cost of debt
The WACC can be calculated using the cost of equity and debt, and the debt-to-equity ratio

Private Company Valuation Issues

There is no market value for the debt or equity of a private company
The financial statements may have fewer years of data, less detail, and more errors
The accounting standards may be different from those used by public companies
Personal and business expenses may be intermingled, and salaries and dividends may be difficult to distinguish

Key Person Discount

The key person discount is a discount applied to the value of a private company to reflect the expected loss of cash flows if the key person (often the owner) leaves
The discount can be reduced by taking actions to mitigate the risk of the key person leaving, such as:
- Agreeing to stay on for a transition phase
- Agreeing not to start a similar business in a certain radius

Liquidity Discount

The liquidity discount is a discount applied to the value of a private company to reflect the lack of liquidity
The discount can be estimated based on the size and type of the company, and the market conditions

Valuation of Angko Restaurant

The Angko Restaurant has a debt of $750,000 and a yearly interest payment of $65,000
The restaurant has a revenue growth rate of 10% for the next 5 years, and a return on capital (ROC) of 20%
The reinvestment rate is 50% for the next 3 years, and 30% from year 4 to year 5
The operating profit is expected to grow at the GDP rate (3%) in the terminal year
The beta for publicly traded restaurants is 1.25, and the average R-squared from the beta regression is 0.45
The debt-to-capital ratio is 45%

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Description

Calculate the debt-to-equity ratio for Abel Stores based on book values and market values. This quiz is part of a finance practice exercise.