Appunti di Entrepreneurship and New Venture Finance

FCFE.

They are both expected results but the time factor and level of risk have an

influence on it.

Cost of capital

Asset side perspective WACC

→

cost as an average expectation that takes into account the expectation of the

shareholder and lenders.

Where:

ke = equity cost of j;

j

k = debt cost of j;

ij

S = equity of j;

j

D = financial debt;

j

= tax rate

τ

1 - in the NI we have the interest as cost so they reduce the part of income

τ →

where we apply the tax rate; debt has a fiscal advantage.

k * D = expected financial cost and reduces the part of gross profit to which we

ij

apply the tax rate.

k *S is not an explicit cost from the NI but an opportunity cost and we can’t use it to

ij

reduce the level of taxes.

ke > k since the risk of the shareholder is higher than the one of the lender.

j ij

When the company fails, the firm sells its assets first; first this extraordinary cash

flow is used to pay debts and the residual part for the shareholder (= which can also

be 0). Moreover the volatility of returns for the shareholders is high while usually for

debt we have a fixed interest rate.

We use the WACC as a discount rate when computing the enterprise value.

Example:

we invest 100 and we have a return i = 10%

in t we have C = 100

0

in t C = 110

1

in t C = 121

2

because of the capitalization of interest so:

2

100 (1 + 0,1) = 121 2

but actualizing this value to t we have that the present value is 121/(1 + 0,1) = 100

0

We use the Wacc for actualizing the FCFF.

In the actualization of the FCFE we will use the cost of equity.

Equity side perspective Equity cost

→

where:

= coefficient of systematic risk

β

j

Rf = risk free rate remuneration of time factor

→

R = expected return of market portfolio

m

The rational investor diversified his portfolio as much as possible and the max

diversification is when the risk depends only on the systematic risk which comes

from the context.

Asset side evaluation

EV = Enterprise Value Asset value

→

FCFF = FCF to firm

TV = terminal value

When we evaluate the firm we have to actualize all cash flows. But we also have to

consider the terminal value: the TV is the part of value that depends on the next

period after our prediction in a certain number of years and has to be actualized.

Equity side evaluation

The terminal value can be measured in many ways:

1) No growth

FCFF normal capacity of the firm to generate cash flow over the cost of

capital.

2) Growth rate

a) stable

b) Two-stage growth model

c) Three-stage growth model

DCF and growth in case of start up firms

Asset side:

Equity side:

We suppose g = g

n

st

1 equation ke =1

j

a pe money condition

→

b post money condition

→

c terminal value

→

This logic is applicable to the early stages of the life cycle of start-up: from the seed

stage to the venture capital business, therefore, earlier stages in the IPO.

But when we are not in t we have to calculate it from that period on; for example, if

0

we start from t = 3:

The problem is the WACC: how do we cover investments by using equity and debt?

We can adopt different compositions.

The choice on the capital structure and the combination between equity and debt

has an effect on the enterprise value or not? Many theories were made; the most

popular states that in terms of EV and Total value the capital structure is neutral

when there is no tax rate; but tax rate exists and we can fail.

4.4. The APV (Adjusted Present Value) method

The APV method is a specific case of the DCF, and it is adopted when it’s needed to

measure the unlevered value of a venture. The unlevered value refers to the value of

an initiative when it is entirely financed with equity; while the levered value refers

to the value of a venture that is financed both with equity and debt.

According to APV, financing with debt has both advantages and disadvantages. As an

advantage, there’s the tax shelter. However, more debt causes more costs; and,

therefore, an increased default risk

1) unlevered value

2) correct the u.v. taking into account both fiscal benefits and rik coming from

debts = leverage value

Trade-off theory and cost of default

Capital structure (financial lever) problem:

EV on the y axis and the financial leverage on the x-axis

st

1) 1 theory no tax and no risk of failure there is no impact of the leverage (no

→

fiscal benefit).

2) blue line 2nd theory no risk of failure but there is the fiscal benefit so when

we increase debt we have lower risk of capital and higher value.

3) trade off theory we take into account also risk of failure we can exploit the

→

benefits of debt up to a certain point from which the value decreases as the

risk increases.

p = probability of failure * c = cost of failure (direct or indirect)

Rf k = cost of debt under risk of failure = interest rate

→ i

ke = opportunity cost

The 1st is too theoretical; the 3rd theory/theorem is Modigliani Miller theory is

important since:

a) the value of the firm depends on the quality of investments

b) Also in the extreme case where there is no possibility of failure the debt

impacts in a positive way the return for shareholders but in a negative way the

price of shares. The leverage amplifies the volatility of equity.

Unlevered equity value (W )

u

FCFFo = net operating cash flow (operating cash - taxes);

ke = unlevered equity cost (cost of equity in absence of debt), so it is low;

u

g = expected growth rate.

This value is lower than when we have debt.

Present value of the fiscal advantage (PVFA)

t = fiscal rate;

k = cost of debt;

i

D = debt.

j

Discounted value of the cost of default (VCF)

p = default probability

BC = discounted default cost

Levered value (WL )

How do we use this method in the case of a startup?

Normally, in the early years there are no tax benefits since the profit is negative. The

financial leverage is lower than the average of existing firms - short run debts for

the management of the liquidity, not for realizing fixed investments. The most part

of risk is unlevered but in general, the risk of failure for a startup is very high.

The overall risk depends primarily on the operational risk.

For each level of debt, the cost of failure is higher than the average of existing firms.

4.5. Market multiples and comparable transactions

Empirical methods to calculate the economic value. The so-called market methods

are based on the following hypotheses:

Price (per shares) * N° of shares.

In case of a private company, it is needed to select some public firms that can be

considered as comparables.

a) Market multiples approach

The estimate of a private firm’s value can be done using the value of public

companies, operating in the same sector and with similar characteristics.

First, there’s the selection of one or more benchmark public companies.

Hence, the ratio among the price of the public company and a reference

parameter is our multiple. Multiple= Market Value of the comparable/

reference parameter Target firm value= multiple x reference parameter of the

firm.

Market multiple is Price Earning (PE)

Where price is the one on the capital market; p is an accounting value; you

consider an average earning E:

where:

PEs = Price earning of cluster s

PVj = Present value of j

Ej = Current earning of j

But this method is flawed because:

1) Private company is unlike a public one

2) Speculative nature of the price

High levels of PE of firms which does not reflect the structure of the

company.

with the price to book value you have at the denominator the equity value.

4.6. Venture capital method

4.7. Equity cost

4.7.1. The need to contextualize the equity cost analysis

There is no best model to measure the equity cost, to analyze the risk return

profile of the business.

Key word: Contextualization of the valuation object in the subjective

perspective of the investor.

In venture finance processes the valuation objects are new ventures.

The actors involved in a venture finance process tend to have a long term

perspective.

4.7.2. The equity cost analysis as a piece of actualization process

DCF and equity cost (ke )

j

Asset side valuation

● - Expected results = Free cash flows to firm

- Discount rate

Equity side valuation

● - Expected results Free cash flows to equity

- Discount rate = ke

j

APV and equity cost

4.7.3. The equity cost analysis in the neoclassical perspective

The market equilibrium hypothesis is linked to the following assumptions:

Informational efficiency

● Everyone has the availability of the best information about each

⇒

stock; therefore, among the different types of investors, there aren't

differences about the possibility to optimize investment decisions.

Economic rationality of investors

● Each investor aspires to maximize his (or her) economic utility.

⇒

The economic utility is maximized when for a given level of risk the

expected return is maximum, or for a given level of expected return the

risk is minimum.

Each investor has the knowledge to make a risk-return analysis.

The personal emotions of investors don't act on their investment

decisions. Market prices = Fair values (or intrinsic values)

No stock is overestimated or underestimated.

→

The three fundamental theoretical steps:

Markowitzs’s Theory Financial portfolios’ optimization

● ⇒

Tobin’s Theorem Expected return in equilibrium conditions

● ⇒

Capital Asset Pricing Model (CAPM) of Sharp and others Expected return in

● ⇒

function of systematic risk

4.7.4. The Capital Asset Pricing Model (CAPM)

Specific risk and systematic risk (= part of risk you cannot diversify ≠ systemic

risk).

Assumptions:

Market equilibrium;

● Diversification as tool for optimizing financial portfolios

● The investor operates just as a take-over and take-risk: He can’t affect

● the market prices.

Variables of CAPM:

Risk free rate (Rf);

● Market return(R );

● m

Beta (ꞵ ) = measure of systematic risk.

● j ke = f(Rf, R , ꞵ )

j m j

CAPM Formula:

where

Although to measure beta we need statistics:

where:

= covariance j,m;

σ

j,m

2j = variance m

σ

Covariance is a measure of how much two random variables change together.

The covariance j,m measures how j return changes for each change of the

average return of market portfolio and vice versa. Variance m measures the

capital market volatility

If ꞵ = 1 we can with one inves