Private Firm Valuation

Question 1

How does estimating cost of equity differ between private and public firms?

Answer 1

CAPM and APM models use past prices of asset, which is not available for private firms. Thus private firm risk estimation cannot be based on past prices.

Question 2

How to estimate private firm cost of equity?

Answer 2

From comparable firm beta by calculating average market unlevered beta, then estimate the firm levered beta based on an assumed D/E, then estimate cost of equity.

Question 3

Total risk/cost of equity of private firm higher or lower than that estimated using market betas?

Answer 3

Higher because the private firm owners often have all or the bulk of their wealth invested in the business rather than diversified in the market.

Question 4

How to estimate private firm cost of debt?

Answer 4

1. Assume it is same as cost of debt for similar firm in the industry. 2. Assume it is same as interest rate based on estimated bond rating. 3. Calculate using interest expense and the outstanding debt.

Question 5

How to estimate firm cost of capital?

Answer 5

1. Calculate the cost of equity and cost of debt. 2. in estimating debt ratio, either use the industry average debt ratio or the optimal debt ratio. 3. Must use consistent debt ratio for beta calculation, debt rating and cost of capital weights.

Question 6

Characteristics of doing cash flows for a private firm

Answer 6

Shorter history, different accounting standards, intermingling of personal and business expenses, separating “salaries” from “dividends”.

Question 7

Key ideas of estimating firm value from cash flow.

Answer 7

1. Need to estimate cash flow first and the cost of capital. 2. If selling firm to a private business, then use the total beta and the cost of equity from that. 3. If valuing firm for an IPO, stay with market beta and the associated cost of capital.

Question 8

How to take account into valuation motives?

Answer 8

1. Selling to another private investor: a illiquidity discount and a control premium (sell more than 50% of business) 2. Selling to public firm: create different classes of shares, options and warrants, may also have a premium if public firm can take advantage of the private firms.