Monday, March 10, 2014

Enterprise Value Lending: Valuation and Credit Risk

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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