Did Breakingviews.com Forget Corporate Finance 101?

So I'm minding my own business, reading the weekend edition of the Wall Street Journal when it hit me: someone clearly skipped out on Corporate Finance 101. It brought back a rush of memories that are truly priceless. Consider the following story:

Buyout Shops' Dull Edge

Is the buyout industry losing its deal-making edge? A tussle for high-end furniture and knickknack retailer Restoration Hardware may pose an answer. Buyout firm Catterton Partners offered to buy Restoration for $366 million earlier this month. Now, it may face a rival bid from Sears Holdings.

Before the credit crunch hit, strategic buyers such as Sears found themselves at a disadvantage relative to private-equity firms. Fast forward to today: Catterton's weighted-average cost of capital in this deal will be much higher than Sears's.

In addition to Catterton injecting its own equity, four public shareholders will roll their existing shares into the new leveraged entity. All told, equity will make up 70% of Restoration's capital structure -- well more than the 30% that characterized precrunch deals. So the deal's after-tax cost of capital will be 16%, assuming the equity investors expect a return of 20% a year.

Sears has a net debt-to-cash-flow ratio of less than one. It could raise debt to buy Restoration or use some of its cash. Either way, its cost of equity -- the upper limit on its overall cost of capital -- isn't much above 10%. This means Sears could offer a much higher price. The deal looks like another good illustration of just how critical a component cheap debt was to private equity's golden age.

Whoa. Using the way one finances an asset to determine the intrinsic value of that asset? I don't think so. Now, for those with a taste for history, see if you can remember this one: The Coca-Cola Corporation and Columbia Pictures. Coca-Cola bought Columbia in 1982, which led to a very stormy relationship over the ensuing years. After much strategic and financial engineering, Columbia was finally purchased by Sony in 1989. Many thought that Coca-Cola paid an absurd price for Columbia back in 1982, with one significant driver of over-valuation: using its AAA-credit rating and low cost of equity as inputs to the cost of capital with which to discount back Columbia's volatile cash flows. This yielded a very high NPV, as the discount rate did not reflect the riskiness of the cash flows being purchased but the riskiness of the entity doing the purchasing. Is this any way to value a business? Of course not. The way a deal is financed should not impact the value of the operating business. The value of financial engineering and leverage is a separate potential source of value (and risk) that needs to be considered separately. This was one of the case studies I learned as a young banker of how not to value a company.

So here we are 25 years later reading a story that is basically making the Coca-Cola argument: since Sears has a lower cost of capital than a private equity shop, it should be able to pay a higher price for the business. NO. NO. NO. Please, no. Deals are hard enough when you pay a theoretically fair price for the business then when you grossly overpay since you didn't use sound corporate finance principles when valuing its cash flows. I wouldn't have expected to see this kind of weak financial analysis in the Wall Street Journal. Tsk, tsk.

Comments

[Roger]

David, baby, I know assets don't have WACCs. I think you know that I know this. I think you also know that I know M&M, and that I also know the non-linear nature of WACC and that I did take this into account in my discussion. I think you know that I understand the impact of increasing leverage on the cost of equity, which is why WACC is a smile, not a straight line. And interest rates do matter in my formulation, as equity risk premia are impacted as is the risk-free rate. And moreso, they matter because of the WACC itself, which should be the target's WACC, not the acquirer's WACC for reasons mentioned previously. And I couldn't disagree more that assets themselves and the cash flows they generate lack intrinsic values.They do. Anyway, it's been good sparring, but my fingers hurt. We can go bowling sometime and discuss further.

[David Harper]

Roger,

Assets don't have WACCs, funds (sources of capital) have WACCs. The WACC (the discount rate) is a direct function of the capital structure and an indirect function of the asset riskiness (e.g., cost of equity is function of BOTH investor expectations/hurdles and asset riskiness). In this regard, the 'essence' of the article is justified and your headlines isn't (i.e., if RH achieves a lower WACC under Sears than Catterton, then RH has a higher value under Sears).

Your mistake is to cite straw man examples--misapplications of a "cheap debt" fallacy--to throw out any connection to capital structure. The Merck example isn't persuasive: Merck may start with low rating but that doesn't prove it is wise to leverage (or that it's investment into an entity will enjoy WACC). Saying capital structure change WACC (and that some leverage creates value) is not an endorsement of cheap debt/high leverage.

The idea that capital structure is irrelevant is classic M&M, among the most well researched areas in finance. The M&M irrelevance propositions are merely building blocks that step the practical conclusion that capital structure is nonlinear with WACC. (The cheap debt fallacy that you are using to impugn the article is to leverage up a firm without counting the implicit cost of more debt).

But even more, if your idea were true, if assets had intrinsic values as only function of their own risk and not any function of investor requirements (hurdles), then interest rates changes wouldn't change the value of assets. But they do, because as in bond math, investors pay based on a yield expectation and that expectation is a function of the asset.

So, I am not simply wrong...I may be too precise, I'd admit to that...the (theoretical) argument you can make against the article (but not the cheap debt one you make with the straw man example) is how can another buyer earn a lower COE.

But does it matter? I think it's interesting because your view (capital structure irrelevance) leads to a conclusion that, I think, is untrue: that assets have intrinsic values. Under the practical M&M framework (capital structure matters), it is a comfortable conclusion that no such thing exists: a fair price is partly subjective in addition to, of course, being a function of expected future cash flows and their riskiness.

I hope that helps...

[Matt]

Roger - You're talking about the difference between what a firm CAN pay vs. what they SHOULD pay. Obviously, higher ability to pay for an asset (i.e. either via more cash on hand and less equity/debt or more debt vs. equity which has a lower WACC etc.) has no bearing on whether or not that asset is fairly priced. Just because I have a billion dollars burning a hole in my pocket doesn't mean I should spend it on moon-drilling futures. If I had a thousand bucks it would still be just as a bad as an investment.

That part should be obvious to anyone.

HOWEVER...What I think the WSJ writer was trying to do was imply that exactly these poor decisions get made with more money burning holes - excess cash or cheap capital influences decision-making. The writer just didn't explain it well (and probably doesn't really understand the distinction - I'm guessing he observes this type of irrational behavior and thinks it's what "always" happens.)

[Roger]

David, no way, man. You are missing the point on a few big counts. Forget about the capital structure/leverage issue. That's not the point of my post and not the essence of the issue of the original article, either. Yes, I understand the benefits of tax shields and WACC minimization, blah, blah, blah. I can unlever and relever betas using CAPM, conduct option-based equity valuations and all the rest as well as anyone.

You are correct about discounting cash flows back at the WACC (if you are looking at NOPAT - net operating profit after tax), BUT WHOS' WACC? The WACC reflecting the RISKINESS OF THE ASSET BEING PURCHASED, not the acquiror. The hurdle rate argument is a bunch of crap. Using that logic, Merck or any other AAA-rated, underleveraged credit should be in the LBO business since they have a lower discount/hurdle rate and therefore should be willing to pay a higher price. This is just wrong and if this example doesn't make it plain I can't help you.

Your depiction is exactly the reason why Coca-Cola overpaid for Columbia. Exactly. Because cash flows aren't static; they entail risk that directly relates to the nature of the business. And using the framework you've suggested has nothing to do with the nature of the acquired business and does not give weight to the riskiness of the cash flows in question. It's just wrong. Sorry. The differential in perceived value associated with a business should arise from strategic issues, i.e., growth strategies, synergy with existing assets, cost reduction approaches, etc., not discount rates.

Sorry for my emotional outburst but I can't stand how there is still ambiguity around this issue.

[David Harper]

Hi Roger - Interesting, I agree with half of what you say. But I think the author is consistent with CorpFin. (M&M irrelevance does say asset value is independent of capital structure, but only in a frictionless vacuum).

Isn't it typical to discount a firm's cash flows at WACC (or equity flows at COE)?. Against the idea of discounting at WACC, he gives two effects: First, that a leveraged firm is more valuable (to a point); e.g., 30% leveraged firm is less valuable than a 70% leveraged firm. Surely this is true if for no other reason than deductible interest. Second, that Sears, as buyer, has lower cost of equity than PE. And this makes for a lower WACC. This is the half I sort of agree with. But it's debatable: the buyer discounts based on required return. I'd argue discount rate is about the buyer (his opportunity cost) and not an function intrinsic to the asset. Here, it simply means Sears can look at the same exact cash flows and, having a lower required yield, can afford to pay more. Put another way, there is no intrinsic value; instead there is an estimate of future cash flows and varying yield requirements that determine varying willing-to-pay prices.