The Daily Technical #90: How do you estimate the cost of debt?

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OVERVIEW OF YESTERDAY’S QUESTION
Walk me through a DCF.

The most common approach to building a DCF is the unlevered DCF, which involves the following steps:

1. Forecast Unlevered Free Cash Flows ("FCFF" or "UFCF"): First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage, should be forecast explicitly for a 5 to 10 year period.

2. Calculate Terminal Value ("TV"): Next, the value of all unlevered FCFs beyond the initial forecast period needs to be calculated – this is called the terminal value. The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach.

3. Discount Stage 1 & 2 CFs to Present Value ("PV"): Since we are valuing the company at the current date, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital ("WACC").

4. Move from Enterprise Value - Equity Value: To get to equity value from enterprise value, we would need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the value of non-operating assets such as cash or investments and subtract debt. Then, we would account for any other non-equity claims such as minority interest.

5. Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value by diluted shares outstanding as of the valuation date. For public companies, the equity value per share that our DCF just calculated can be compared to the current share price.

6. Sensitivity Analysis: Given the DCF’s sensitivity to the assumptions used, the last step is to create sensitivity tables to see how the assumptions used will impact the implied price per share.

Common Mistakes

1. Overlooking thorough forecasting of unlevered free cash flows. Ensure each year's cash flow is explicitly forecasted for accuracy, typically over 5 to 10 years, to reflect realistic business growth.

2. Choosing a terminal value approach without considering which fits the scenario best. Decide between the growth in perpetuity or exit multiple approach based on company and industry characteristics.

3. Miscalculating net debt. Verify you include non-operating assets correctly and understand adjustments for non-equity claims, such as minority interest.

TL;DR

• Forecast UFCF: Project unlevered free cash flows for 5-10 years, excluding debt impacts for a firm's operational cash generation.

• Determine TV: Estimate terminal value using growth in perpetuity or exit multiples for post-forecast UFCFs.

• Discount to PV: Apply WACC to discount forecasted cash flows and terminal value to present value, aligning with the current valuation date.

• Transition to Equity Value: Subtract net debt and non-equity claims from enterprise value; adjust for cash, investments, and minority interests.

• Calculate Price Per Share: Divide equity value by diluted shares outstanding for DCF-derived value per share.

• Conduct Sensitivity Analysis: Evaluate how assumption changes affect the implied share price, showcasing the DCF's variable sensitivity.

TODAY’S QUESTION
How do you estimate the cost of debt?

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