DCF Valuation with changing cost of capital

CFA Level II Equities
#1

Hi everyone,

I have a problem with a dcf valuation model I came up with:

I want to value a high, young growth company. Since young companies usually bear higher risk than matured ones, the cost of capital slightly decreases until the company reaches mature status (end of forecasting period).

Now my question: Which coc do I use when discounting the cf? The one of “today” or do I have to discount each year with it’s individual discount rate?

Thanks!

#2

Are you calculating WACC or equity cost of capital? Only company beta will change or capital structure as well?

#3

Assumption is firm stays fully equity financed.

I took an industry average beta and correlated the firms beta to it - like 60% in the beginning and 100% when the company reaches mature status e.g. end of forecasting period.

The higher coc in the beginning are basically due to higher beta (higher than the industry standard), capital structure stays 100% equity

#4

There’s two things you can try:

  1. If you know r0 and rn you can find the average (rn+r0)/2

  2. If the decrease is gradual and linear you can do linear interpolation to find the relevant r every successive year and discount each year cash flow using a different r.

So let’s say your time horizon is 5 years and (t=0, r=10%) and (t=5, r=5%) then you can fill in the missing years by finding the incremental decreases in r

(r5-r0)/(t5-t0)= -5/5=-1% per year

t=0, r=10% t=1, r=9% t=2, r=8% t=3, r=7% t=4, r=6% t=5, r=5%

#5

Cost of capital is not that volatile. Assuming only equity is a little bit unrealistic, isn’t it? Remember that bonds are not the only way of debt. A credit card, a revolving credit line, a bank loan, etc are also indentified as debt.

If your company is very young, using a discounted cash flow model is not the best way. Rather use sales comparables, your assumption of only 100% equity sounds like a bad private company. You can not use betas that easy, thats another problem.

However, if you can have a strong view of the cash flows of the company, maybe a very low volatile and predictable cash flows despite it is a young company, you can estimate only 3 to 5 years cash flow and then estimate an exit value. Estimating “mature” cash flows is just guessing a lot. Use a single WACC rate for those 3 or 5 years of forecasting. Obviously add a reasonable risk premium to that wacc.