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CHALLENGING THE DISCOUNT RATE BRENDAN DAW &
SIMON DALGARNO
© Leadenhall Corporate Advisory 2015
CHALLENGING THE DISCOUNT RATE
2 CHALLENGING THE DISCOUNT RATE
© Leadenhall Corporate Advisory 2015
3 CHALLENGING THE DISCOUNT RATE
REWARD AND RISK
3
Is the reward worth the risk? How do we measure the trade-off?
© Leadenhall Corporate Advisory 2015
4 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
5 CHALLENGING THE DISCOUNT RATE
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%
© Leadenhall Corporate Advisory 2015
6 CHALLENGING THE DISCOUNT RATE
COMMON USES
Project evaluation
Business case modelling
Decision making
Impairment testing
Business and asset valuation
Regulated pricing models
ROI calculations
6
© Leadenhall Corporate Advisory 2015
7 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
8 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
9 CHALLENGING THE DISCOUNT RATE
VALUE IMPACT OF DISCOUNTING
9
© Leadenhall Corporate Advisory 2015
10 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
11 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
12 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
13 CHALLENGING THE DISCOUNT RATE 13
OPTIMISING WACC
© Leadenhall Corporate Advisory 2015
14 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
15 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
16 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
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
© Leadenhall Corporate Advisory 2015
18 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
19 CHALLENGING THE DISCOUNT RATE
• RSM Bird Cameron Business Acquisition and Impairment Review 2010
19
GUIDELINE PUBLIC COMPANY METHOD
RSM Bird Cameron Business Acquisition and Impairment Review 2010
© Leadenhall Corporate Advisory 2015
20 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
21 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
22 CHALLENGING THE DISCOUNT RATE
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
© Leadenhall Corporate Advisory 2015
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.
23 CHALLENGING THE DISCOUNT RATE
© Leadenhall Corporate Advisory 2015
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.
24 CHALLENGING THE DISCOUNT RATE
© Leadenhall Corporate Advisory 2015
ABOUT LEADENHALL CORPORATE ADVISORY
Valuation
Business and company valuations
Independent Expert’s Reports
Compliance Valuation (PPA, Impairment, Options)
Technology and IP valuations
Transactions
Acquisitions, divestments and MBO’s
Mergers and acquisitions advice
Succession planning
Growth strategies and development plans
Leadenhall has been established for 28 years and we specialises in business valuations and in mergers and acquisitions advice.
© Leadenhall Corporate Advisory 2015
25 CHALLENGING THE DISCOUNT RATE
© Leadenhall Corporate Advisory 2015
leadenhall.com.au
CONTACT
ADELAIDE
Level 1, 31 Franklin St
Adelaide SA 5000
Contact: Simon Dalgarno
T +61 8 8385 2207
M +61 416 003 737
Contact: Brendan Daw
T +61 8 8385 2222
M +61 434 223 508
SYDNEY
Level 11, 65 York St
Sydney NSW 2000
Contact: Richard Norris
T +61 2 8823 6224
M + 61 416 152 823
Contact: Dave Pearson
T + 61 2 9199 1103
M + 61 431 487 016
MELBOURNE
Level 9, 440 Collins St
Melbourne VIC 3000
Contact: Elena Saarbrucken
T +61 3 9607 1330
M +61 457 721 722
26 CHALLENGING THE DISCOUNT RATE