Introduction and Approaches

to Business Valuation

DCF method, APV method,

Relative Valuation method
and Real Option approach
DCF and APV

Example
The value of a project to the firm = the value of the
project to an unlevered firm (NPV)
+ the present value of the financing side effects
(NPVF)

There are five side effects of financing:

- The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing
Financial Risk Management gains or losses
We consider a project of the Company X, the
timing and size of the incremental after-tax
cash flows for an all-equity firm are:

Rs.1,000Rs.125 Rs.250 Rs.375 Rs.500

--------I------------I------------I----------------I--------------I------
0 1 2 3 4
The unlevered cost of equity is r 0 = 10%
NPV = - 1000 + 125/(1.10) + 250/(1.10) 2
+ 375/(1.10)3 + 500/(1.10)4
= - Rs. 56.50
The project would be rejected by an all-
equity firm X as NPV < 0 or negative
We want to see how adding Debt influence our
decision, because adding debt would give us a
benefit of tax shield.
We consider that the firm finances the project
with Rs.600 of debt at an interest rate@ 8%. Xs
tax rate is 40%, so they have an interest tax
shield worth = 0.40Rs.6000.08 = Rs.19.20
each year.
The net present value of the project under
leverage is:
APV = NPV + NPVF
APV = Rs. 56.50 + 4t= 1 Rs.19.20/(1+0.08)t
APV = Rs.56.50 + Rs. 63 59. = Rs. 7.09
So, X should accept the project with debt.
 Another method of calculation of the
actual NPV of the loan:
NPVF = NPV LOAN
= 600 - 4t= 1
600x.08x(1-0.4)/ (1+0.08)t

- Rs.600/(1+0.08)4
= Rs. 63.59
APV = NPV + NPVF
= 56.50 + 63 59. = Rs. 7.09
DCF Method:

The DCF method values the company on basis of the net

present value (NPV) of its future free cash flows (FCF)*
which are discounted by an appropriate discount rate (r).
The formula for determining the NPV of numerous future
cash flows is shown below:

= n t=0 / (1 + )t,

where FCF is free cash flow and r is the discount rate.

*The free cash flow (FCF) is the amount of cash not

required for operations or reinvestment
The process of valuing a company with the
DCF method contains different stages.
In the first stage scenarios are developed to
predict future free cash flows (FCF) for the
next five to ten years.
Afterwards, an appropriate discount rate,
the weighted average cost of capital (WACC)
is required to be determined to discount all
future FCFs to calculate their NPVs.
In the next step, the terminal value (TV) is to
be calculated.
The TV is the net present value of all
future cash flows that accrue after
the time period that is covered by
the scenario analysis. In the last step
the net present values of the cash
flows are summed up with the
terminal value.

Company value = n t=0 / (1 +

)t
+ Terminal value
Calculation of the Free Cash Flow
There are two ways of using cash flows for the DCF
valuation.
1. to use the free cash flow to the firm (FCFF) which
is the cash flow that is available to debt- and equity
holders, or
2. to use the free cash flow to equity (FCFE) which is
the cash flow that is available to the companys
equity holders only.
When using the FCFF, all inputs have to be based on
accounting figures that are calculated before any
interest payments are paid out to the debt holders.
The FCFE in contrast uses figures from which
interest payments have already been deducted.
Using the FCFF as base for the
analysis will result in the enterprise
value of the company, using the
FCFE will give the equity value. Since
an acquirer usually takes over all
liabilities, debt and equity, the FCFF
is more relevant than the equity
approach.
The formula for calculating the FCFF
is shown below.
=
net operating profit after tax ()
+ Depreciation and Amortization
(&) capital expenditure ()
net
working capital ()
There are more methods that can be
used to calculate the FCFF, but they
will all result in the same value.
Discount rate:

Determining the discount rate

requires extensive analysis of the
companys financing structure and
the current market conditions. The
rate that is used to discount the FCFs
is called the weighted average cost
of capital (WACC).
The Weighted Average Cost of Capital
(WACC)

The WACC is one of the most

important input factors in the DCF
model. Small changes in the WACC
will cause large changes in the firm
value. The WACC is calculated by
weighting the sources of capital
according to the companys financial
structure and then multiplying them
with their costs.
The the formula for the WACC
calculation is:

=
( / + ) x
+
( / + ) x t
Cost of Equity
The cost of equity (COE) is calculated
with the help of the capital asset
pricing model (CAPM). According to
the CAPM, the required ROE, or in
this case the COE is derived using
the following formula:

= + ( )
Although the risk-free interest rate () is
the yield on T-Bills or T-Bonds, many
professionals use the Mumbai Interbank
Offer Rates (MIBOR) as an approximation
for the short-term risk free interest rates.
The input factor is the risk, that holding
the stock will add to the investors
portfolio. It is derived using linear
regression analysis, where the excess
return of the stock is the dependent
variable and the excess market return is
the independent variable. The beta is the
slope of the regression line.
Cost of Debt
The cost of debt (COD) is the interest
rate that a company has to pay on its
outstanding debt. The COD after tax
can be calculated as follows:

= . (1 )
where is the interest rate on
outstanding debt and t is the
effective tax rate paid by the
company.
If the company has various interest
rates on different amount of debt
outstanding, the COD is the weighted
average cost of debt of these
different tranches, adjusted for tax:

= (1 ) . n a=1 a . a
Calculation of WACC

By putting the formulas of COE and

the COD, we get the full formula for
the WACC including all factors that
influence the discount rate:
=
( / + ) x ( + ( ))
+
( / + ) x ( x (1 ))
Calculation of the Terminal Value (TV)
The terminal value is the NPV of all
future cash flows that accrue after
the time period that is covered by
the scenario analysis. Since, it is
difficult to estimate how a company
will develop over a long period of
time, the terminal value is based on
average growth expectations, which
are easier to predict.
The constant perpetual growth rate
g, together with the WACC as the
discount rate r allows for the use of a
simple dividend discount model to
determine the terminal value.
The TV can be expressed as:
= n t=0 x (1 + ) / ,
where the is one period before
the TV period.
Determination of Company Value
After having determined the NPV of
the cash flows accruing within the
scenario period and the TV, that is
discounted to its net present value.
Both NPVs are then added together
to give the enterprise value or the
equity value, depending on whether
the valuation is based on FCFFs or
FCFEs.
The valuation equation of the firm is:

Company value = n t=0 / (1 +

)t
+ Terminal value
Incorporating terminal value
equation, we get the following
expression:
= / (1 + )
+ / (1 + )+1
Cost of Equity

Usually the company value is

calculated using different levels of
leverage to find an optimal financing
structure. The determined company
value can then be used for
determining the equity value. The
total business value could be divided
by the number of shares outstanding
to determine a fair share price for
listed companies.
The rates for discount factor and
perpetual growth rate depend on
each specific firm, its business
situation and other variables. In
general, the more risky a firm is, the
higher its capital costs (WACC) are.
The perpetual growth rate should be
the same for all industries, since
according to the arbitrage theory in
the long run all companies and
industries will grow by the same rate.
 The Adjusted Present Value
Approach of Valuation of Firm
In the adjusted present value (APV)
approach, first the value of the firm
without debt is calculated.
Second, we add debt to the firm, to
understand the net effect on value by
considering both the benefits and the
costs of borrowing. The benefit
relates to tax benefit while costs of
borrowing may increase risk of failure.
The Mechanics of APV Valuation
We estimate the value of the firm in
three steps. We begin by estimating the
value of the firm with no leverage.
We then consider the present value of
the interest tax savings generated by
borrowing a given amount of money.
Finally, we evaluate the effect of
borrowing the amount on the probability
that the firm will go bankrupt, and the
expected cost of bankruptcy.
We assume that the primary benefit
of borrowing is a tax benefit and that
the most significant cost of borrowing
is the added risk of bankruptcy.
Value of Unlevered Firm

The first step in this approach is the

estimation of the value of the unlevered
firm. This can be accomplished by
valuing the firm as if it had no debt, i.e.,
by discounting the expected free cash
flow to the firm at the unlevered cost of
equity.
In the special case where cash flows
grow at a constant rate in perpetuity,
the value of the firm is easily computed.
Value of Unlevered Firm =

FCFF0 (1 + g)
--------------------
eu- g

where FCFF0is the current after-tax

operating cash flow to the firm,euis
the unlevered cost of equity and g is
the expected growth rate.
Expected Tax Benefit from Borrowing
This is the calculation of the
expected tax benefit from a given
level of debt. This tax benefit is a
function of the tax rate of the firm
and is discounted at the cost of debt
to reflect the riskiness of this cash
flow. If the tax savings are viewed as
a perpetuity, then

Value of Tax Benefits

Note:

The tax rate used here is the firms

marginal tax rate and it is assumed
to stay constant over time. If we
anticipate the tax rate changing over
time, we can still compute the
present value of tax benefits over
time, but we cannot use the
perpetual growth equation cited
above.
Estimating Expected Bankruptcy
Costs and Net Effect
In this step we evaluate the effect of
the given level of debt on the default
risk of the firm and on expected
bankruptcy costs. This requires the
estimation of the probability of
default with the additional debt and
the direct and indirect cost of
bankruptcy.
 Ifais the probability of default after the
additional debt and BC is the present
value of the bankruptcy cost, the present
value of expected bankruptcy cost can be
estimated.
PV of Expected Bankruptcy cost
= (Probability of Bankruptcy) x (PV
of Bankruptcy Cost)
= a . BC
Research that has looked at the direct
cost of bankruptcy concludes that
they are small, relative to firm value.
The indirect costs of bankruptcy can be
substantial, but the costs vary widely
across firms.
Shapiro and Titman speculate that
the indirect costs could be as large as
25% to 30% of firm value but
provide no direct evidence of the costs.
Valuing a firm with the APV
approach

We estimate the value of the Firm A

using adjusted present value
approach in three steps.
Step 1: Unlevered firm value
To estimate the unlevered firm value, we
first compute the unlevered beta. As beta
is 1.17, its current market debt to equity
ratio is 79% and the firms tax rate is 30%.
Unlevered beta =1.17 / 1+(1 - 0.3)(0.79)
= 0.75
Using the rupee risk-free rate of 10.5%
and the risk premium of 9.23% for India,
we estimate an unlevered cost of equity.
Unlevered cost of equity = 10.5% +
0.75(9.23%) = 17.45%
The free cash flow to the firm is
estimated to be Rs 212.2 million and
the stable growth rate of 5%. Under
such conditions, the unlevered firm
value is calculated as follows:
Unlevered firm value =
FCFF / (unlevered cost of
equity stable growth rate) =
212.2 / (0.1745 0.05)
= 1704.6 million
Step 2: Tax benefits from debt
The tax benefits from debt are
computed based upon As existing
debt of Rs. 1807.3 million and the
tax rate of 30%:
Expected tax benefits in perpetuity
= Tax rate (Debt)
= 0.30 (1807.3)
= Rs 542.2 million
Step 3: Expected bankruptcy costs
To estimate this, we made two
assumptions. First, based upon its
existing rating, the probability of
default at the existing debt level is
10%.
Second, the cost of bankruptcy is
40% of unlevered firm value.
 Expected bankruptcy cost
=Probability of bankruptcy * Cost of
bankruptcy * Unlevered firm value
= 0.10*0.40*1704.6 = Rs 68.2 million
Value of the operating assets of the firm
= Unlevered firm value + PV of tax benefits -
Expected Bankruptcy Costs
= 1704.6 + 542.2 - 68.2 = Rs 2178.6 million
Adding to this the value of cash and
marketable securities of Rs. 1365.3 million,
we obtain a value for the Firm A of Rs 3543.9
million.
Drawbacks of APV

APV valuation in practice has significant flaws.

The most important is that most practitioners
who use the adjusted present value model
ignore expected bankruptcy costs.
Adding the tax benefits to unlevered firm value
to get to the levered firm value makes firm value
overstated, especially at very high debt ratios,
where the cost of bankruptcy is clearly not zero
and, in some instances, the cost of bankruptcy is
higher than the tax benefit of debt.

 Relative and Asset

Oriented Valuation
And
Approaches followed in
each Valuation Method
Assets based valuation

The goal of company valuation is to give owners,

potential buyers and other interested stakeholders an
approximate value of what a company is worth. There
are different approaches to determine this value but
some general guidelines apply to all of them.
In general there are two kind of possible takeover
approaches. An interested buyer could either buy the
assets of a company, known as asset deal, or the
buyer could take over a majority of the companys
equity, known as share deal. Since taking over the
assets will not transfer ownership of the legal entity
known as the company, share deals are much more
common in large transactions.
Due to the financing of a company by
debt and equity, valuation
techniques that focus on share deals
either value the equity, resulting in
the equity value (Eq. V.) or the total
liabilities, stating the enterprise
value (EV) or firm value (FV). It is
possible to derive the EV from the
Eq. V. and vice versa by using the
following formula:
=
. .
Net debt and the corporate
adjustments are derived with the
following definitions:
= + Sh
+ + h
h h

=
+
+ f h

Relative valuation
In relative valuation, the value of an
asset is derived from the pricing of
'comparable' assets, using a common
variable. With equity valuation, relative
valuation becomes complicated by two
realities. The first is the absence of
similar assets. The other is that
different ways of standardizing prices
(different multiples) can yield different
values for the same company.
There are several valuation techniques
besides the DCF approach. A widely used
method is the trading comparables
analysis. In this method a peer group of
listed companies is built, usually using
firms with similar standard industry
classification (SIC) and other similarities to
the target company like geographic focus,
financing structure, and client segments.
If the company is listed, the equity value
is simply the market capitalization.
The EV can be calculated based on
this Eq. V. Then some multiples are
calculated to state relationship
between EV and Eq. V. to a
companys fundamental data.
Usually the multiples are the
following:
/,
/ ,
/
. ./ .
The median and arithmetic average
of these multiples is then calculated
for the peer group. These figures are
a good approximation for a targets
EV and Eq. V., but they tend to be
lower than actual transaction values,
since trading comparables do not
include majority premiums that have
to be paid when acquiring a majority
stake in a company.
A similar approach to the trading
comparables method is the transaction
comparables valuation approach. The
analysts compare how their company
is priced (using a multiple) with how
the peer group is priced (using the
average for that multiple).
The underlying assumption that while
companies may vary widely across a
sector, the average for the sector is
representative for a typical company.
 There can be wide differences between the company
being valued and other companies in the comparable
firm group and analysts sometimes try to control for
differences between companies.
In many cases, the control is subjective like using PE
ratio. In a few cases, analysts explicitly try to control for
differences between companies by either adjusting the
multiple being used or by using statistical techniques.
PEG ratios are computed by dividing PE ratios by
expected growth rates, thus controlling for differences
in growth and allowing analysts to compare companies
with different growth rates.
For statistical controls, multiple regression can be used,
the resulting regression can be used to estimate the
value of an individual company.