A banker recently asked me a question regarding the use of
projected cash flows for debt service. The question was whether the projected
free cash flows, EBIT x (1-tax rate) + Depreciation-(Capital Expenditures +
Working Capital Increases), could be used to estimate the implied market value
of a firm’s assets. The answer is yes.
Banks use cash flow projections to gauge default risk. They
also use historical book value balance sheet equity to estimate possible loss
in the event of a default (LIED) if the firm is liquidated or reorganized. The
problem with historical book value is it measures money spent, not current
value. This is important for distressed firms whose value at the time of
distress can be different from what was spent due to adverse economic, industry
or management developments. Some investment expenditures may hold up better
than others. This depends on whether the asset’s value is independent or
dependent on the firm as a going concern. Assets which are largely independent
of the firm’s continued existence like real estate hold the value more than
those which are dependent on the firm existence like intangibles.
The projected cash flows, both base case and the downside,
can be used to determine the implied enterprise value of their debtor. If after
capitalizing the base case at reasonable costs of capital and growth, the value
substantially exceeds the debtor’s current market or comparable trading value,
then the projections are probably over optimistic. My preference is to the Adjusted Present
Value approach instead of the Weighted
Average Cost of Capital. This is to isolate possible leverage and tax
distortions.
The downside projections provide estimates of distressed
asset value. This provides a better estimate of LIED than traditional
historical book value measures. This measure can be seen as a proxy mark-to
market asset value. Provided enough value remains to cover the lender’s claims,
then the bank can be repaid either thru a refinancing or sale of the debtor
should it wishes to exit. Usually, lenders rely on enterprise value as a
secondary repayment source. They try to limit their exposure to a discount of
the downside value similar to the advance rate on an asset based loan (ABL).
Unlike ABLs, no mechanism exists to modify the advance rate should conditions
change-absent financial covenants.
Regulators recognize enterprise value as an alternative
supplemental repayment source provided:
1) Enterprise value is validated independent of the
loan origination function.
2) Sound consistent methodology is used. They favor
the discounted cash flow approach over the multiple of EBITDA method.
3) Estimates of a range of plausible stress
scenarios versus a single point estimate are used.
4) The estimates are periodically updated to
reflect changing conditions.
Valuation provides the best measure of a firm’s debt
capacity and its credit risk.
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