Confusion regarding the appropriate Discounting Rate

Replies to This Discussion

Permalink Reply by REN on February 8, 2010 at 7:29pm

From Renaldo,

I have been through this exersise in the past month, and put various arguments to Accountants and a large development Bank. The results are:

If a Company Rate = Company cost of funds
An Individual = 91 day bill rate + margin = % above BR required in the market place.


Regards.

▶ Reply to This

Permalink Reply by Brent Wheeler on February 8, 2010 at 7:46pm

How do they derive their "margin" Renaldo!!! That is the big issue.

▶ Reply to This

Permalink Reply by Chad Ellis on February 24, 2010 at 4:06pm

Sorry for a delayed reply, but I just noticed this.

The discount rate depends somewhat on the terms of the deal. There's obviously a big difference between a loan secured by the assets of the entrepreneur and an equity investment. Assuming you're talking about equity, the discount rate is based on the project, not the individual -- although the team is key in determining whether the project is likely to succeed!

I think most angel investors should look for annual returns of at least 20%.

Perhaps an even bigger issue is that the cash flows of most startups are far less reliable than the projects of established businesses (which are themselves rarely accurate). Rather than starting with projections and asking what discount rate you should apply the first step is probably to take a very serious look at the projections themselves and how they were calculated.

▶ Reply to This

Permalink Reply by Brent Wheeler on February 25, 2010 at 4:57am

Chad - hard to disagree with this.... and, Brierley and Meyers always say... look to the reliability of the cashflows. So boring.. so essential!!

▶ Reply to This

Permalink Reply by Mike Adhikari on February 28, 2010 at 3:15am

Typically, angel investing implies the the entrepreneur has an idea on a napkin or some a model that proves the concept. All start-ups are not "angel" investing, like starting a infra-structure projects or buying distressed real estate. For angel investing, where capital is used primarily in development and there is nothing left if the idea fails, angel investors expect 35-70% return (as a reference, expected equity returns by private equity was 30-35%, now it is 20-25%). The actual expected return for a specific project is driven by the project-risk; however, each investor perceives such risk differently depending, partly, on their own experience, and their comfort in the jockey (the entrepreneur).

For such investments, there is no debt (because there is no revenue or profit to service the debt). Hence, there is no WACC. For such investments, investors do not use beta for decision making. However, entrepreneurs often have analysis done for investor presentation thinking investors may ask. Unfortunately, investors are more interested in understanding the idea, the forecast, the assumptions and risks. Too often, over emphasis on such analysis in a presentation is a negative. (I have been a presenter of such analysis in my early years, and have recently been on the other side judging such start-ups along with angel investors). A friend of mine has made such investment over the last 10 years (Google, Inktomi, Zappos, etc.) He summarized VC decision-making as follows: Take 5th year EBITDA, cut it by half, multiply it by anticipated EBITDA market-multiple for such investment 5 years out, and divide by 5. That gives the PV of the firm's CF. The value of the firm is what the capital requirement is, not what the PV is. He would put up the required capital for 80% of the equity, to start the negotiations. Of course, this is an over-simplification of the process. But it does show how angel investors think.

Ankit: In your example, compute equity CF and use expected equity return as the discount rate to calculate NPV. Do not use WACC, even if project is going to have debt financing.

▶ Reply to This

• ‹ Previous
• 1
• …
• 3
• 4
• 5
• Next ›
• Page