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*Not Intended for Publication. For Classroom Purposes Only*

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Module 1 –Overview of Valuation Concepts and Methods
What is Valuation?
Valuation refers to the process of determining the present value of a company or an asset.
It can be done using a number of techniques. Analysts that want to place value on a company
normally look at the management of the business, the prospective future earnings, the market
value of the company’s assets, and its capital structure composition.
Valuation may also be used in determining a security’s fair value, which depends on the
amount that a buyer is ready to pay a seller, with the assumption that both parties will enter the
transaction.
During the trade of a security on an exchange, sellers and buyers will dictate the market
value of a bond or stock. However, intrinsic value is a concept that refers to a security’s perceived
value on the basis of future earnings or other attributes of the entity that are not related to a
security’s market value. Therefore, the work of analysts when doing valuation is to know if an
asset or a company is undervalued or overvalued by the market.
Valuations can be performed on assets or on liabilities such as company bonds. They are
required for a number of reasons including merger and acquisition transactions, capital budgeting,
investment analysis, litigation, and financial reporting.
OVERVIEW …
There is no doubt that the “value” is the defining measurement of any market in the economy of
today. Value is all about how much something is worth, whether in an estimate or exact amount.
When somebody invest, they expect the “value” of their investment to increase by an amount that
is acceptable to them or sufficient enough to compensate the risk or sacrifice they took,
incorporating the time value of money. As we say, in everything we do, we need to sacrifice. That
sacrifice has value, giving away something that is valuable to him expecting another value, the
return or profits he is willing to accept given the value of his sacrifice.
Therefore, knowing how to measure value or how to create value is an essential tool for everybody
to be able to make a decision, wise decisions.
Basic Principles of Accounting
NOTE:
In performing valuations, one should be equipped with analytical skills. These skills should not
only be on intelligence and reasonable ideas, good recommendations and excellent analysis. It
should also be anchored with the principles that guide accountants to provide ethical practices for
decision making.

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Just a quick recap ….
The accounting principles are concepts that serve as basis in preparing and interpreting the
financial statements. These are the basic foundations that guide prepares into presenting the
financial reports to the users and the users to be confident of what they read.
The Conceptual Framework of Accounting specifically mentions the underlying assumption of

going concern which contemplate the realization of assets and settlement of liabilities in the
normal course of business.
The basic concepts or principles of accounting are:
Going Concern Assumption

The going concern principle, also known as continuity assumption, means that a business entity
will continue to operate for at least another accounting period. This principle is the reason why
assets are generally presented in the balance sheet at cost rather that at fair market value and
long-term assets are included in the books until they are fully utilized and retired.
Accrual Basis of Accounting

The accrual basis of accounting means that the financial statements are prepared where income
and expenses must be recognized in the accounting periods to which these are incurred. This
means that revenue or income is recognized when earned regardless of when payment is
received and expenses are recognized when incurred regardless of when these are paid.
Examples:
a. XYZ Company rendered repair services to a client on October 10, 2019. The client
paid after 90 days which is January 9,2020. The income will be recognized when the
service has already been rendered. Hence, the income should be recognized in
October, 2019 even if it has not yet been collected as of that date.
b. Burgis Company received its electricity bill for the month of December, 2019 on
January 5, 2020 and paid it on January 31,2020. When should the electricity expense
be recorded? The electricity expense shall be recorded in December, 2019 even if the
bill has been paid and received in January, 2020 because electricity consumption
pertains to the month of December, 2019.
Accounting Entity Concept

The accounting entity concept recognizes a specific business enterprise as one accounting entity,
separate and distinct from the owners. In other words, a company has its own identity set apart
from its owners and can represent its own self.
For example, if JXY Company buys a vehicle to be used as delivery equipment, then it is
considered a transaction of the business entity and not by the owner even if the owner is the
signatory of the transaction. However, if Mr. Ben, owner of JXY Company, buys a car for personal
use using his own money, that transaction is not recorded in the company's accounting books
because it is not a transaction of the company. If the money used to buy the car is company’s
funds, then the payment will be treated as company advances to the owner which can be
deducted from owner’s future dividends or share in profits.

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Time Period
The time period assumption, also known as periodicity assumption, means that the life of an
enterprise is subdivided into time periods (accounting periods), which are usually of equal length,
for the purpose of preparing the financial statements. An accounting period is usually a 12-month
period – either calendar or fiscal. A calendar year refers to a 12-month period ending December
31 and fiscal year is a 12-month period ending in any day of the year except December 31.
Monetary Unit Assumption

This means that transactions and events when recorded in the books of accounts should be
measured in monetary terms.
The monetary unit assumption has two characteristics – quantifiability and stability of the
currency. Quantifiability means that records should be stated usually in the currency of the country
where the financial statements are prepared and stability means that the purchasing power of the
said currency is stable or constant and that any insignificant effect of inflation is ignored.
There are other principles derived from the above concepts, like: matching principle, revenue or
expense recognition principle, historical cost principle, consistency, materiality, neutrality or
completeness. The financial statements should possess the above attributes or concepts so that
these can be reliable to decision makers.
• Foundations of value
There is no doubt that the “value” is the defining measurement of any market in
the economy of today. Value is all about how much something is worth, whether in an
estimate or exact amount. When somebody invest, they expect the “value” of their investment
to increase by an amount that is acceptable to them or sufficient enough to compensate the
risk or sacrifice they took, incorporating the time value of money. As we say, in everything
we do, we need to sacrifice. That sacrifice has value, giving away something that is valuable
to him expecting another value, the return or profits he is willing to accept given the value
of his sacrifice .
Therefore, knowing how to measure value or how to create value is an essential tool
for everybody to be able to make a decision, wise decisions.
• Definition of valuation
Valuation is the analytical (quantitative) process of determining the current or projected

worth (value) of an asset or something. There are several techniques or methods available
to be used in doing valuation. Each of these methods may give different results or value,
what matter is how this will be used in the decisions why such valuation activity is being
done.
Valuation determines the economic value of a business, asset or company.
• Frameworks for valuation
Conceptual frameworks of valuation is about the issue of what affects or what drives
the value to change. A company’s value is driven by its ability to earn a good or healthy
return on invested capital (ROIC) and by its ability to grow. Healthy rates of return and
growth result in high cash flows, the ultimate source of value. Discussions on this will be done

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in detail in the topic, step by step process o f valuation.
• Concepts of valuation
Valuation is based on economic factors, industry variables, and on the analysis of

financial statements and the entire outlook of the firm. Valuation process will determine
the long-run fundamental economic value of its common stock or preferred stock. Different
concepts of valuation are based on the following:
1. Going concern value

2. Liquidation value
3. Market value
4. Book value
5. Intrinsic value
Details of the above concepts will be discussed in the respective topics.
When dealing with the valuation process, it is important to get as many facts as possible
with clear goals on what is the purpose of this valuation.
1. Why are you valuing?

2. What are you trying to accomplish with this valuation?
• Objectives/uses of valuation
Valuation is useful when we are trying to determine the fair value of an asset. Fair
value is the amount which is determined by what is the buyer willing to pay and the seller is
willing to sell under the conditions that both parties are willing o r voluntarily enter in the
exchange transaction.
• Importance/Rationale of valuation
Business valuation is an important exercise since it can help in improving the

company. Here are some of the reasons why is there a need to perform a b u s i n e s s
valuation.
Although the goal of valuation is to determine the fair market value, there is no one
way to be certain of the ultimate price paid. Typically, it depends on many factors including
industry, sector, valuation method and the economic conditions. You can also count on a
fact; you can have your business valued by two p ro f ess i ona ls and you will come up with two
different answers

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Various reasons for performing a business valuation
• Litigation
In a court case, such as an injury case, divorce, or where there is an issue with the
value of the business, someone may need to provide proof of company’s worth that could be
the basis of claims for any damages, or be based on the actual worth of your businesses
and not inflated figures estimated by a lawyer.
• Exit strategy planning
In cases where there is a plan to sell a business, it is wise to come up with a base
value for the company and then come up with a strategy to enhance the company’s profitability
so as to increase its value as an exit strategy. Your business exit strategy needs to start
early enough before the exit, addressing b o t h involuntary and voluntary transfers.
A valuation with annual updates will keep the business ready for unexpected and
expected sale. It will also ensure that you have correct information on the company fair
market value and prevent capital loss due to lack of clarity or inaccuracies.
• Buying a business
Sellers and buyers of business usually have different opinions on the worth of the
business. However, the real business value is what the buyers are willing to pay. A sound
business valuation should consider market conditions, potential income, and other similar
concerns to ensure that the investment being done is viable. Business buyers must exercise
prudence by normally hiring a business broker who can help you with the process.
• Selling a business
As mentioned, sellers and buyers usually have different opinions on the worth of the
business. The sellers, however, would want to be certain that they are getting what it is
worth, thus they may have to perform their valuation p r o c e ss as well.
• Strategic planning
The true value of assets may not necessarily be reflected on the assets schedule,
and if there has been no adjustment of the balance sheet for various possible changes, it
may be risky. Having a current valuation of the business will give you good information that
will help you make better business decisions. As in the financial reporting standards, the use
of current value a c c o u n t i n g is more evident.
• Funding
Bankers, financing companies or any potential investors require an objective valuation

when someone is negotiating or applying for credits, loans or any funding requirements.
Professional documentation of your company’s worth is usually required since it enhances
your credibility to the lenders or p o t e n t i a l investors.

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• Selling a share in a business
For business owners, proper business valuation enables you to know the worth of your
shares and be ready when you want to sell them. Just like during the sale of the business,
you ought to ensure you get good value from your share.
Business valuation is a critical financial analysis that needs to be done by a valuation

expert who has appropriate qualifications. Business owners are able to negotiate a tactical
sale of their entity, plan an exit strategy, acquire f i n a n c i n g , and reduce the financial risk
during litigation.
• Fundamental principles of valuation or value creation
Business valuation involves the determination of the fair economic value of a company
or business for various reasons as mentioned earlier.
Key Principles of Business Valuation
The following are the key principles of business valuation that business owners who
want to create value in their business must know.
• The value of a business is defined only at a specific point in time.
The value of a business usually experiences change every single day. The earnings,
cash position, working capital, and market conditions of a b u s i n e s s are always changing.
The valuation made by business owners a month or years ago may not reflect the true current
value of the business. The value of a business requires consistent and regular monitoring.
This valuation principle helps business owners to understand the significance of the da te of
valuation in the process of business valuation.
• Value primarily varies in accordance with the capacity of a business to generate future
cash flow
A company’s valuation is essentially a function of its future cash flows except in in

unusual situations where net asset liquidation may lead to a higher value .
The consideration here is the term “future.” It implies that historical results of the
company’s earnings before the date of valuation are useful in predicting the future results of
the business under certain conditions. Another consideration is the term “cash flow.” It is
because cash flow, which takes into account capital investments, working capital changes, and
taxes, is the true determinant of business value. Business owners should aim at building a
comprehensive estimate of future cash flows for their companies. Even though making
estimates is a subjective undertaking, it is vital that the value of the business is validated.
Reliable historical information will help in supporting the a s s u m p t i o n s that the forecasts will
use.
• The market commands what the proper rate of return for investors
Market forces are usually in a state of flux, and they guide the rate of return that is

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needed by potential buyers in a particular marketplace. Market forces include the type of
industry, financial costs, and the general economic conditions. Market rates of return offer
significant benchmark indicators at a specific point in time. They influence the rates of return
wanted by investors over the long term. Business owners need to be wary or concerned of
the market forces in order to know the right time to exit that will maximize value.
• The value of a business may be impacted by underlying net tangible assets
Business valuation measures of the relationship between t h e operational value of a

company and its net tangible value. Theoretically, accompany with a higher underlying net
tangible asset value has higher going concern value. It is because of the availability of more
security to finance the acquisition and lower risk of investment since there are more assets
to be liquidated in case of bankruptcy. Business owners need to build an asset base. For
industries that are not capital intensive, the owners need to find means to s upp o r t the
valuation of their goodwill.
• Value is influenced by transferability of future cash flows
How transferable the cash flows of the business are to a potential acquirer will impact
the value of the company. Valuable businesses usually operate without the control of the
owner. If the business owner exerts a huge control over the delivery of service, revenue
growth, maintenance of customer
relationships, etc., then the owner will secure the goodwill and not the business. Such a kind
of personal goodwill provides very little or no commercial v a l u e and is not transferable.
In such a case, the total value of the business to an acquirer may be limited to the
value of the company’s tangible assets in case the business owner does not want to stay.
Business owners need to build a strong management team so that the business is capable of
running efficiently even if they left the company for a long period of time. They can build a
stronger and better management team through enhanced corporate alignment, training, and
e v e n through hiring.
• Value is impacted by liquidity
This principal function based on the theory of demand and supply. If the marketplace
has many potential buyers, but there are a few quality acquisition targets, there will be a rise
in valuation multiples and vice versa. In both open market and notional valuation contexts, more
business interest liquidity translates into more business interest value. Business owners need
to get the best potential purchasers to the negotiating table to maximize price. It can be
achieved through a controlled auction process.
Although they are technical valuation concepts, the basics of the valuation principles
need to understood by business owners to help them increase the valuation of their
businesses.
REFERENCE:
(source: corporatefinanceinstitute.com)

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Unit 2 – Asset Valuation Methods
Overview:
Asset is defined as transactions that will yield future economic benefits brought
a b ou t by past events. Given the definition, valuation should be observed to address the
d e te r m ina t i on of the amount of returns that will be earned or generated from the
t r a n s ac t i o n s . The challenge is determining the factors that will affect the value of the
assets .
Valuation concepts are geared towards determining the price of equity based on
the value of its assets. The higher the value of the assets or investment represents the
h i g h e r the projected returns to be generated. Valuation approach is different depending
o n the investment opportunity available. This module shall focus on asset-based
v a l u a t i o n approached for going concern opportunities.
Valuations can and should be used as a powerful driver of how you manage your
business. The purpose of a valuation is to track the effectiveness of your strategic decision-
making process and provide the ability to track performance in terms of estimated change in
value, not just in revenue. There are two common valuations: (1) Asset valuation, and (2)
Equity valuation.
What is Asset Valuation?
This pertains to the value assigned to a specific property when a company or asset
is to be sold, insured, or taken over. The assets may be categorized into tangible and
intangible assets.
Asset valuation is the process of determining the fair market or present value of
assets, using book values, absolute valuation models or comparable. The assets may
include investments in marketable securities like stocks and bonds; tangible assets like
buildings and equipment; or intangible assets like brands, trademarks or patents.
What is Equity Valuation?
Equity valuation is a general term which is used to refer to all tools and techniques
used by investors to find out the true value of a company’s equity. It is often seen as the
most crucial element of a successful investment decision. Every participant in the stock
market either directly or indirectly makes use of equity valuation while making investment
decisions. The users of equity valuation are the small individual investors who make up the
vast majority of stock market investors, the government and institutional investors and
entities that hedge funds.

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Valuation Methods
When valuing a company as a going concern, there are three main valuation methods
used by industry practitioners: (1) DCF analysis, (2) comparable company analysis, and
(3) precedent transactions.
There are several business opportunities in various industry. In Management
Accounting, capital budgeting techniques are very useful in determining which among the
alternative opportunities is the most economic and would be a better choice. In order to
determine the value, information is the key. The best and most relevant information m u s t
be factored in. For going concern business opportunities, there are different a pp r oa che s
that can be used, the most popular are: discounted cash flows or DCF a n a l y s i s ,
comparable companies’ analysis, and economic value added.
As shown in the diagram above, when valuing a business or asset, there are three
broad categories that each contain their own methods. The Cost Approach looks at what it
costs to build something and this method is not frequently used by finance professionals to
value a company as a going concern. Next is the Market Approach, this is a form of relative
valuation and frequently used in the industry. It includes Comparable Analysis Precedent
Transactions. Finally, the discounted cash flow (DCF) approach is a form of intrinsic valuation
and is the most detailed and thorough approach to valuation modeling (source:
https://corporatefinanceinstitute.com/).

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DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where one
forecasts the future business free cash flow and discounts it back at present day. It is the
most detailed of the three approaches, requires the most assumptions, and often produces
the highest value which also often result in the most accurate valuation.
In Financial Management, it has been discussed that a way to determine the va lue of an
investment opportunity is by determining the actual cash generated by a p a r t i c u l a r
asset. Recall that discounted cash flows analysis can be done by determining th e net
present value of the free cash flows of the investment opportunity. In Conceptual
Framework and Accounting Standards, it was discussed the that the cash flows are
presented and analyzed based on their sources and activities which are categorized as
o pe ra t i ng , investing and financing. The free cash flows are the amounts of cash
available for distribution to both debt and equity claim from the business or asset. This is
c a l cu l a t e d from the net cash generated from operations and for investment over time.
Since this is a going concern opportunity, certain risk and returns are inherent this is
quantified in the form of terminal cash flows. Terminal cash flows can be computed by
estimating the perpetual value of cash to be generated by the opportunity or in some
c a s e s these represents the salvage value of the opportunity.
The net present value of the free cash flows represents the value of the assets.
It may be recalled further that the assets are financed by debt and equity. Hence, these
are the claims which are presented at the right side of the Statement of Financial
P o s i t i o n , under an account form of reporting.
Same principle applies that the best opportunity is the one that will yield the highest
net present value or solely if the opportunity will result into a positive amount it should be
accepted. Conservatively, the total outstanding liabilities must be considered and deducted
versus the asset value to determine the amount appropriated to the equity s ha r eho l de rs .
This is called the equity value. The opportunity that will result to the h i g h e s t equity value
is considered.
DCF Analysis is most applicable to use when the following are available:
• Validated Operational and Financial Information

• Reasonable appropriated cost of capital or required rate of return
• New quantifiable information

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Supposed ABC Company is projected to generate Php10 Million every year for the
next 5 years and beyond. The estimated terminal value is Php50 Million. The required
return is 10%. It was noted further that there is an outstanding loan of Php50 Million. If you
are going to purchase 50% of ABC Company, how much would you be willing to pay?
in million pesos
Free Cash Flows - Firm 10.00(year1) 10.00(year2) 10.00(year3) 10.00 (year4) 60.00 (year5)
NPV @ 7% 76.65
Less: Outstanding Loans 50.00
Free Cash Flows to Equity 26.65
Based on the foregoing information, the value of PUP’s equity is Php26.65 Million.
If the amount at stake is only 50% then the amount to be paid is Php13.33 Million
(Php26.65 x 50%).
Comparable Analysis
Comparable company analysis, also called trading multiples or public market

multiples, is a relative valuation method in which you compare the current value of a
business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or
other ratios. Multiples of EBITDA are the most common valuation method. This is the most
widely used approach, as they are easy to calculate and always current.
In Financial Management, financial ratios are used as tools to assess and analyze
business results. Recall that one of these purposes can be used to determine th e value.
These financial ratios are P/E Ratio, Book to Market Ratio, Earnings Per Share, Dividend
Per Share. Multiples can also be used in comparative company analysis. The beauty of
the ratios is that it creates better and relevant comparison knowing that opportunities or
investments have distinct drivers of their performance.
The following are the consideration for doing a comparable company analysis:
• Total and absolute values should not be compared

• Variables used in determining the ratios must be the same
• Period of observation must be comparable
• Non quantitative factors must also be considered

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Example of Comparable Table

(source: https://corporatefinanceinstitute.com/).
Economic Value Added
The most conventional way to determine the value of the asset is through its
economic value added. In Economics and Financial Management, economic value added
(EVA) is the convenient for this is assessing the ability of the firm to support its cost of
capital with its earnings. EVA is the excess of the earnings after deducting the cost of
capital. The assumption is that the excess shall be accumulated for the firm the higher
the excess the better.
The elements that must be considered in using EVA are:
• Reasonableness of earnings or returns

• Appropriate cost of capital
Other factors to be considered in Valuation
Once the value of the asset has been established, there are factors that can be
cons ide red to properly value the asset. These are the earning accretion or dilution,
e q u i t y control premium and precedent transactions.
Earning accretion are additional value inputted in the calculation that would account
for the increase in value of the firm due to other quantifiable attributes like potential growth,
increase in prices, and even operating efficiencies. Earnings dilution wo rks differently.
But in both cases, these should also be considered in the sensitivity a n a l y s i s .
Equity Control premium is the amount that is added to the value of the firm in order
to gain control of it. Precedent transactions, on the other hand, are experiences, u s u a l l y
similar with the opportunities available. These transactions are considered risks t ha t may
affect further the ability to realize the projected earnings.

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Precedent Transactions
Precedent transactions analysis is where you compare the subject company to other
businesses that have recently been sold or acquired in the same industry. These transaction
values include the take-over premium included in the price for which they were acquired.
Example of Transaction Analysis

(source: https://corporatefinanceinstitute.com/).
Leveraged Buyout (LBO)
A leveraged buyout model, or an LBO, is a type of company acquisition where total

acquisition proceeds are financed with a substantial portion of borrowed funds. There are
two parties involved in a leveraged buyout – the buyer company & the target company. In
LBO, the acquiring company finance the acquisition with a mix of equity (usually the down
payment) and debt (for the remaining balance). The target company’s assets serve as
security or collateral for the debt.
In LBO, the acquiring company usually targets companies that are in trouble but have
valuable market, maybe financially or have incurred heavy losses. After the buyout, the
acquiring company channels the management and technical expertise and funds to the
target company. Sometimes, employees are allowed to participate in the LBO through an
employee ownership plan, which may provide tax advantages and improve employee
productivity.

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Example:
Barbers Corp. wants to buy Gupit Corp without investing a lot of capital. The value of
Gupit Corp. is Php2,000. Barbers Corp. invests Php200 of its own equity and for the remaining
Php1,800, it borrows at an interest rate of 5% per annum.
In the first year of operations, Barbers Corp earns Php200 (10%) from the cash flow of
Gupit Corp. Now the total value of Gupit Corp. is Php2,200. Barbers Corp. repays its interest
on debt for Php90 (5% of Php1,800) which is an expense to the company. Thus, Barbers Corp
is left with Php110 available for equity shareholders. Barbers Corp earns Php110 on its original
investment of Php200.00 which is 55% return on equity on this transaction (Php110/Php200).
How much return Barbers Corp. would have earned had it financed the entire
transaction by equity? To acquire Gupit Corp, Barbers Corp. has to invest Php2,000. In the
next one year, Barbers Corp. earned Php200.00 from the cash flow of Gupit Corp. thus, its
total return is only 10% (Php200/Php2,000).
We can therefore say that the returns on leveraged buyout are much higher than
financing the buyout by equity alone.
Absolute and Relative Valuation
There are two basic methods of valuing equity stock: (1) the absolute evaluation and
(2) relative evaluation. These methods have its own advantages and disadvantages so one
has to make wise decisions on what techniques to use for the asset valuation.
There are two general approaches in valuation techniques: (a) the discounted cash flow
valuation techniques, where the value of the stock is estimated based upon the present value
of some measure of cash flow, including dividends, operating cash flow, and free cash flow;
and (b) the relative valuation techniques, where the value of a stock is estimated based upon
its current price relative to variables considered to be significant to valuation, such as earnings,
cash flow, book value, or sales.
These approaches and all of these valuation techniques have several common factors:
(1) all of them are significantly affected by the investor’s required rate of return on the stock, (2)
all valuation approaches are affected by the estimated growth rate of the variable used in the
valuation technique like dividends, earnings, cash flow, or sales.

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Absolute Valuation Techniques
Discounted Dividends
The most straightforward measure of cash flow is dividends because these are clearly
cash flows that go directly to the investor. However, this dividend technique is difficult to apply
to firms that do not pay dividends during periods of high growth, or that currently pay very
limited dividends because they have high rate of return of investment.
Discounted Residual Income
This cash flow measure is the operating free cash flow, which is generally described as
cash flows after direct costs and before any payments to capital suppliers are made. The
discount rate employed is the company’s weighted average cost of capital (WACC).
Discounted Free Cash Flow
Another cash flow measure is free cash flow to equity, which is a measure of cash flows
available to the equity holder after payments to debt holders and after allowing for expenditures
to maintain the company’s asset base. Since these are cash flows available to equity owners,
the appropriate discount rate is the company’s cost of equity.
Relative Valuation Techniques
A possible problem with the discounted cash flow valuation models is that it is possible
to derive intrinsic values that are substantially above or below prevailing prices. The relative
valuation techniques advantage over discounted cash flow valuation is that they provide
information about how the market is currently valuing stock at several levels that is, the
aggregate market, alternative industries, and individual stocks within industries
The relative valuation techniques are appropriately considered under two conditions:
(1) there are good set of comparable entities wherein comparable companies are similar in
terms of industry, size, and risk, and (2) the aggregate market and the company’s industry are
not at a valuation extreme where they are not either undervalued or overvalued.

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Importance of Asset Valuation
Asset valuation plays a key role in finance and consists of subjective and objective
measurements. The value of a company's capital assets is straightforward to value, based on
their book values and replacement costs. The value can easily be ascertained on tangible
assets. However, there is no figure on the financial statements that tell investors exactly how
much intangible assets like brand or intellectual property are worth. Companies can overvalue
goodwill in an acquisition as the valuation of intangible assets is subjective and can be difficult
to measure.
There are many reasons for valuing assets, some of which are the following:
a). Right Price

Asset valuation helps identify the right price for an asset when it is offered to be bought or
sold because the buyer won’t need to pay more than the asset’s value nor will the seller be
paid less than the asset’s value.
b). Taxes
Taxes is inherent to a property and by doing asset valuation, taxes are considered and
calculated accurately.
c). Company Merger

In merging two companies or acquiring a company, asset valuation is important because
it helps both parties size up the business.
d). Loan Application

Asset valuation is needed for the lender to determine the loan amount that can be
borrowed by a company by offering its assets as collateral.
e). Audit
Public companies are regulated, which means that they need to present audited financial
reports to the investors. Part of the audit process involves verifying the value of assets
Methods of Asset Valuation
Cost Method
This is the easiest way of asset valuation where the value of the asset is based on the
carrying cost or purchase price and replacement costs.
Tangible assets refer to assets that are physical or that can be seen, which have been
purchased to produce products or services.

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To compute for the value of a tangible asset:

- Refer to the balance sheet and get the total assets.
- From the total assets, deduct the total value of the intangible assets.
- Then deduct the total value of the liabilities. What is left are the net tangible assets
or asset valuation.
Consider the following simple example:

Balance sheet total assets Php 5,000,000
Less: Total intangible assets (Php 1,500,000)
Total liabilities (Php 1,000,000)
Total tangible assets Php 2,500,000
Intangible assets are assets that take no physical form. They may include patents, logos,
franchises, and trademarks. For example, a multinational company with assets of Php15
billion goes bankrupt one day, and none of its tangible assets are left. It can still have value
because of its intangible assets, such as its logo, patents or trademarks that many investors
and other companies may be interested in acquiring.
Market Value Method
This method bases the value of the asset on its prevailing market price or its projected
price when sold in the market. In the absence of similar assets in the market, the
replacement value method or the net realizable value method is used.
Base Stock Method
This method requires a company to keep a certain level of stocks whose value is
assessed based on the value of a base stock. This accounting method is used in valuing
inventories by carrying on the books a minimum quantity of a commodity at the same low
fixed price from year to year and valuing the quantity in excess of the minimum at a
separate price which is usually the lower of cost or market value.
Standard Cost Method
This method uses expected costs instead of actual costs, often based on the company’s
past experiences. The costs are obtained by recording differences between expected and
actual costs.
Example:
Levis, Inc. purchases its denim from a local supplier with terms of net 30 days, FOB
destination points. This means that title to the denim passes from the supplier to Levis when
L e v i s receives the material. When the denim arrives, Levis will record the denim received
in its Direct Materials Inventory at the standard cost of Php3 per yard and will record the
liability at the actual cost for the amount received. Any difference between the standard cost
of the material and the actual cost of the material received is recorded as a purchase price
variance.

P a g e | 11
Illustration 1.
Let's assume that on January 2, 2019 Levis ordered 1,000 yards of denim at Php2.90
per yard. On January 8, 2019 Levis receives 1,000 yards of denim and an invoice for the
actual cost of Php2,900. On January 8, 2019 Levis becomes the owner of the material and
has a liability to its supplier. On January 8 Levis Direct Materials Inventory is increased by
the standard cost of Php3,000 (1,000 yards of denim at the standard cost of Php3 per yard),
Accounts Payable is credited for Php2,900 (the actual amount owed to the supplier), and
the difference of Php100 is credited to Direct Materials Price Variance. The entry looks like
this:
The Php100 credit to the price variance account communicates immediately (when the
denim arrives) that the company is experiencing actual costs that are more favorable than
the planned, standard cost.
Illustration 2.
In February, Levis orders 3,000 yards of denim at Php3.05 per yard. On March 1, 2019
Levis receives the 3,000 yards of denim and an invoice for Php9,150 due in 30 days. On
March 1, the Direct Materials Inventory account is increased by the standard cost of
Php9,000 (3,000 yards at the standard cost of Php3 per yard), Accounts Payable is
credited for Php9,150 (the actual cost of the denim), and the difference of Php150 is
debited to Direct Materials Price Variance as an unfavorable price variance:
After the March 1 transaction is posted, the Direct Materials Price Variance account shows a
debit balance of Php50 (the Php100 credit on January 2 combined with the Php150 debit on
March 1). A debit balance in a variance account is always unfavorable—it shows that the total
of actual costs is higher than the total of the expected standard costs. In other words, your
company's profit will be Php50 less than planned unless you take some action.

P a g e | 12
FINANCIAL MODELLING
Financial Modelling is a valuation activity that enable the analyst or investor to
determine the value of an asset or opportunity. This incorporates all factors that may affect
the value. A financial model must clear and auditable. Financial models were created to
aid in coming up with a recommended decision and at the same time can be us ed to
validate the assumptions made.
Financial models are similar to budgets and Financial modelling is similar to

financial planning. The difference is that financial models are usually longer in terms of the
period, more conservative and designed to determine the value not the cash needed of
the firm in the short to medium term. Financial Models are done using spreadsheets. Best
is with the use of electronic spreadsheets; nowadays electronic spreadsheets are
c o n s i d e r e d manual still. There are financial models which are designed electronically or
p r o g r a m m e d in an application.
What are the steps in doing a financial model for going concern
opportunities?
Gather historical information and references
Historical information must be made available before the financial model is to be

c o ns t r u c t ed . Historical information may be generated from, but not limited to the
following: audited financial statements, corporate disclosures, contracts, and peer
information.
Audited Financial Statements are the most ideal reference for the historical
performance of the company. The components of the Audited Financial Statements
enable the analyst or the financial modeler to assess the future of the company based on
i t s past performance. Statement of Income are used to determine the historical financial
p e r f o r m a n c e , Statement of Financial Position is used to determine the book value of
the assets and the disclosed stakes of the debt and equity financiers, Statement of Cash
F l o w s illustrate how the company historically financing its operations and investments.
Statement of Changes in Stockholder’s Equity provides the information on how much is
t h e claim and dividend background of the company. One of the most important
comp onen ts of the financial statements are the Notes to the Financial Statements. It
p r o v i d e s the summary of important disclosure that should be considered in the
valuation. The financial modeler must be able to quantify these disclosures and more
importantly t h e risks involved.
Establish drivers for growth and assumptions
Once the historical information is gathered and validated, drivers and assumptions
can be established by conducting financial analysis. Again, in this part, financial ratios may
be used as tools to determine the growth drivers and assumptions. Trend analysis will also
help you establish the trajectory of growth pattern. The financial modeler must assess
whether the company can sustain the pattern otherwise it is conservative to assume a less
aggressive growth. To illustrate, if the sales volume grows in the last 5 years at the rate of

P a g e | 13
15% per year. It must be assessed whether the average year on year growth will be
sustained or may be surpassed. In here, skills of scenario a n a l y s i s will be required.
Scenario analysis as discussed in Financial Management will r e q u i r e to determine
different scenarios and incorporates the probability of occurrence. Normally the weighted
growth pattern will be considered in the long-term financial p e r s p e c t i v e .
PUP Company’s historical production grows 10% per year. It is expected that in
the next five years the probability are as follows:
Scenario Rate Probabilty

A 5% 10%
B 10% 40%
C 15% 50%
With the given information, the weighted average growth rate to be used is 12%. Determine
the reasonable cost of capital
In determining the reasonable cost of capital, the financial modeler must be able
t o use the appropriate parameters for the company. Generally, cost of debt and cost of
equity are weighted to determine the cost of capital reasonable for the valuation. For
cos t of debt, the prevailing market interest rates are used. While for the cost of equity,
i n d us t r y average can be conveniently used or internally assess the cost of equity using
t he Capital Asset Pricing Model.
Calculate for the Value using Valuation Methods
Normally in Financial Modelling, DCF is used to calculate for the value. Since mos t
information are already available in Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Return, Profitability Index etc.
Asset Based Valuation for Liquidation
There are instances when different circumstances create doubt that going-
concern assumption is still attainable for businesses. These circumstances may include
economic downturn, bankruptcy, financial distress, unfavorable regulatory environment,
depletion of limited resources (e.g. granite, quarry) as source of business. As a result,
it might not be appropriate to use going-concern techniques when valuing businesses
facing these. An alternative approach is the use of liquidation value. This module
describes liquidation value, its uses for business valuation and decision making and
relevant concepts for c a l c u l a t i o n of liquidation value.
Liquidation value refers to the value of a company if it were dissolved and its
assets sold individually. Liquidation value represents the net amount that can be gathered
if the business is shut down and its assets are sold piecemeal. For example, if a
restaurant closes, the assets such as the kitchen equipment, tables and chairs, and so
on can be sold separately. The liquidation value indicates the present value of the sums

P a g e | 14
that can be obtained through the disposal of the assets of the firm in the most
appropriate way, net of the sums set aside for the repayment of the debts and for the
termination of legal obligations, and net of the tax charges related to the transaction and
the costs of the process of liquidation itself. Liquidation value is the most conservative
valuation approach. Liquidation value can be used for businesses who are closing, are
closed, are in bankruptcy, are in industries that are in irreversible trouble, or going concern
firms that isn’t putting its assets to good use and may be better off closing down and
selling the assets. For distressed companies, the liquidation value conveys relevant
information as it is typically the lower bound of the valuation range.
General concepts considered in liquidation value are as follows:
• If the liquidation value is above income approach valuation (based on going-concern

principle) and liquidation comes into consideration, liquidation value should be used.
• If the nature of the business implies limited lifetime (e.g., a quarry, gravel, fixed-term
company etc.), the terminal value must be based on liquidation.
• Non-operating assets should be valued by liquidation method as the market value
reduced by costs of sale and taxes. If such result is higher than net present value of
c a sh -flows from operating the asset, the liquidation value should be used.
• Liquidation valuation must be used if the business continuity is dependent on
contemporary management that will not stay.
For most companies, the value generated by assets working together and by human
capital applied to managing those assets makes estimated going - concern value
greater than liquidation value. If we exclude the synergies generated by assets working
together or by applying managerial skill to those assets, the value of a company would
likely change depending on the time frame available for liquidating them. For example,
the value of perishable inventory that had to be immediately liquidated would typically
be lower than the value of inventory that could be sold during a longer period of time.
Identifying the type of liquidation that will happen is important because it affects the
costs connected with liquidation of the property, including commissions for those
facilitating the liquidation (lawyers, accountants, auditors) and taxes at the end of the
transaction. That entire outflow affects the final value of the business. Here are the
gradations of liquidation value:
• Orderly liquidation: Assets are sold strategically over an orderly period of time to
attract the most money for the assets
• Forced liquidation: Usually, creditors have sued or a bankruptcy. Filed that calls
for immediate liquidation, so everything gets sold on the market in a hurry
fetching lower prices.
Calculation for liquidation value is somewhat like the book value calculation,
except the value assumes a forced or orderly liquidation of assets rather than book
value. In practice, the liabilities of the business are deducted from the liquidation value of
the assets to determine the liquidation value of the business. The overall value of a
business that uses this method should be lower than a valuation. In calculating the

P a g e | 15
present value of a business or property on a liquidation basis, discount the estimated

net proceeds at a rate that reflects the risk involved back to the date of the original
valuation. Liquidation value can replace the terminal cash flow (based on going concern)
in a DCF calculation in order to compute firm value in case there are years that the firm
will still be operational.
Uses of Liquidation Value Method
For analysts, liquidation value method can be used for making investment
decisions. If the company is profitable and industry is growing too, the company’s
liquidation value will normally be much lower than the share price, since share price
factors g r o w t h aspect which liquidation value does not.
For companies going through a decline phase or if the industry is dying, the
share price may be lower than the liquidation value; this would logically mean that the
company should shut business. To have arbitrage benefits, smart corporate raiders
usually are on a lookout for these kinds of companies. Since the liquidation value is
higher than the market share price, they can buy out the company stock at a lower
price and then sell off t h e company to make risk-free arbitrage profit.
Limitations of Liquidation Value
Summing up the concept, liquidation value reflects the base price for the company.
However, this may not be a very wise tool to measure a profitable company as it ignores
the future growth potential. Nonetheless, this method can be considered to evaluate a
dy ing company as a potential takeover and sell down for profit making.
For companies with proprietorship or partnership model; there may be a high

dependence of profitability on the partners. It may be because of the key partners (their
skill, ability, knowledge, network, etc.) that the business enjoys profitability; and their
liquidation value may not reflect true value unless we value the impact of these key
personnel on business profitability. This leads to a need to calculate the goodwill impact
which is built up by the key personnel to arrive at fair liquidation value. This is model of
valuation is suitable only for such special cases where liquidation is the motive.
However, it is to be noted that this method is far more realistic compared to the book value
method.

P a g e | 16
FORMULAS TO REMEMBER!!!
NET BOOK VALUE OF ASSETS
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔− 𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

NBV of Assets = 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝑺𝒉𝒂𝒓𝒆𝒔
REPLACEMENT VALUE PER SHARE
𝑵𝒆𝒕 𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 ± 𝒓𝒆𝒑𝒍𝒂𝒄𝒆𝒎𝒆𝒏𝒕 𝒂𝒅𝒋𝒖𝒔𝒕𝒎𝒆𝒏𝒕

= 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝑺𝒉𝒂𝒓𝒆𝒔
REPRODUCTION VALUE PER SHARE
𝑹𝒆𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒐𝒏 𝒄𝒐𝒔𝒕
LIQUIDATION VALUE
Present Value of Sale of Asset P xxx

Less: Present Value of Cost for termination
and settlement for Liabilities ( xxx )
Less: Present Value of Tax Charges for the
Transactions an Other Liquidation Costs ( xxx )
LIQUIDATION VALUE P xxx
LIQUIDATION VALUE PER SHARE
𝑳𝒊𝒒𝒖𝒊𝒅𝒂𝒕𝒊𝒐𝒏 𝑽𝒂𝒍𝒖𝒆

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UNIT 3. CALCULATING DISCOUNT RATES and COST OF CAPITAL
Introduction
Financial markets have an important role in economic development process because of attracting investors
and the accumulated savings and directing them to the right investments by the published information that
reflect the market situation and the assets being traded in such a way that gives investors the best choice
among the available investments especially in the efficient markets.
Having said this, investors look for an appropriate return that is commensurate with the risk in this
investment. Therefore, investments must be evaluated before making a decision. There are many
mechanisms that are used in financial analysis and determination of the required return on investments.
The most important of these methods is the capital asset pricing model (CAPM), which is based on the
required return measurement on a number of facts; nature of the relationship and correlation between the
stock returns and market index returns, in addition to the investment risks that the model divided it into
systematic risk and non-systematic risk. (Mullins,1982)
WHAT IS COST OF CAPITAL?
- The cost of using funds; it is also called hurdled rate, required rate of return, cut-off rate,
opportunity cost of capital.
- The weighted average rate of return the company must pay to its long-term creditors and
shareholders for the use of their funds.
The cost of capital is the company's cost of using funds provided by creditors and
shareholders. A company's cost of capital is the cost of its long-term sources of funds: debt,
preferred equity, and common equity. And the cost of each source reflects the risk of the assets
the company invests in. A company that invests in assets having little risk in producing income
will be able to bear lower costs of capital than a company that invests in assets having a higher
risk of producing income. For example, a discount retail store has much less risk than an oil drilling
company. Moreover, the cost of each source of funds reflects the hierarchy of the risk associated
with its seniority over the other sources. For a given company, the cost of funds raised through
debt is less than the cost of funds from preferred stock that, in turn, is less than the cost of funds
from common stock. Why? Because creditors have a senior claim over assets and income relative
to preferred shareholders, who have seniority over common shareholders.
*Not Intended for Publication. For Classroom purposes only*

Page |2
If there are difficulties in meeting

Exhibit 1 Case in point: The satisfaction of claims in the Eastern
obligations, the creditors receive
Airlines’ bankruptcy and liquidation
their promised interest and principal
before the preferred shareholders In millions
who, in turn, receive their promised Claim
dividends before the common
Claim type amount Payout
shareholders. If
the company is liquidated, the funds Secured debt with sufficient collateral $747.1 $747.1
from the sale of its assets are Secured debt with insufficient $453.7 $234.2
distributed first to debt-holders, then collateral
to preferred shareholders, and then to Accrued interest on secured debt $308.2 $174.4
common shareholders (if any funds Unsecured debt $1,575.0 $175.8
are left). An example of the Preferred stock 350.8 $0.0
possibility of insufficient funds to Common stock $820.0 $0.0

pay claimants is the case of Source: Lawrence A. Weiss and Karen H. Wruck, “Information problems, conflicts of
Eastern airlines, which declared interest, and asset stripping: Chapter 11’s failure in the case of Eastern Airlines,” Journal
bankruptcy in 1991, is shown in of Financial Economics, Vol. 48, 1998, p 86.
Exhibit 1. Eastern Airlines’
secured creditors had
collateral (i.e., security) sufficient to pay their claims; all other claimants did not receive their full
claim on the assets of the company because there simply were insufficient funds available at the
time the company liquidated.
For a given company, debt is less risky than preferred stock, which is less risky than common
stock. Therefore, preferred shareholders require a greater return than the creditors and common
shareholders require a greater return than preferred shareholders.
Estimating the cost of capital requires us to first determine the cost of each source of capital we
expect the company to use, along with the relative amounts of each source of capital we expect
the company to raise. Then we can determine the marginal cost of raising additional capital. We
can do this in three steps, as shown in Exhibit 1.
We look at each step in this reading. We first discuss The cost of capital
Exhibit 1:
how to determine the proportion of each source of estimation process
capital to be used in our calculations. Then we
calculate the cost of
each source. The proportions of each source must be Step 1
determined before calculating the cost of each Determine the proportions of each source of
source since the proportions may affect the costs of capital that will be raised
the sources of capital. We then put together the cost
and proportions of each source to calculate the
company's marginal cost of capital. We also Step 2
demonstrate the calculations of the marginal cost of
capital for an actual company, showing just how Estimate the marginal cost of each
much judgment and how many assumptions go into source of capital
calculating the cost of capital. That is, we show that
it's an estimate.
Step 3
Calculate the
weighted average cost of capital

Page |3
The cost of capital for a company is the cost of raising an

additional dollar of capital; therefore, this cost is the company’s marginal cost capital. Suppose
that a company raises capital in the following proportions: debt 40 percent, preferred stock 10
percent, and common stock 50 percent. This means an additional dollar of capital is comprised
of 40¢ of debt, 10¢ of preferred stock, and 50¢ of common stock.
Determining the proportions of each source of capital that will be raised

Our goal as financial managers is to estimate the optimum proportions for our company to issue
new capital -- not just in the next period, but well beyond. If we assume that the company
maintains the same capital structure -- the mix of debt, preferred stock, and common stock --
throughout time, our task is simple. We just figure out the proportions of capital the company has
at present. If we look at the company's balance sheet, we can calculate the book value of its debt,
its preferred stock, and its common stock. With these three book values, we can calculate the
proportion of debt, preferred stock, and common stock that the company has presently. We could
even look at these proportions over time to get a better idea of the typical mix of debt, preferred
stock and common stock.
But are book values going to tell us what we want to know? Probably not. What we are trying to
determine is the mix of capital that the company considers appropriate. It is reasonable to assume
that the financial manager recognizes that the book values of capital are historical measures and
looks instead at the market values of capital. Therefore, we must obtain the market value of debt,
preferred stock, and common stock.
If the securities represented in a company's capital are publicly-traded -- that is, listed on
exchanges or traded in the over-the-counter market -- we can obtain market values. If some
capital is privately placed, such as an entire debt issue that was bought by an insurance company
or not actively traded, our job is tougher but not impossible. For example, if we know the interest,
maturity value, and maturity of a bond that is not traded and the yield on similar risk bonds, we
can get a rough estimate of the market value of that bond even though it is not traded.
Once we determine the market value of debt, preferred stock, and common stock, we calculate
the sum of the market values of each, and then figure out what proportion of this sum each source
of capital represents. But the mix of debt, preferred stock, and common stock that a company has
now may not be the mix it intends to use in the future. So while we may use the present capital
structure as an approximation of the future, we really are interested in the company's analysis
and resulting decision regarding its capital structure in the future.
Estimating the marginal cost of each source of capital
A. The cost of debt

The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose
you borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the
lender for the use of her money. Since Congress allows you to deduct from you income the interest
you paid, how much does this dollar of debt really cost you? It depends on your marginal tax rate
-- the tax rate on your next dollar of taxable income. Why the marginal tax rate? Because we are
interested in seeing how the interest deduction changes your tax bill. We compare taxes with and
without the interest deduction to demonstrate this.

Page |4
Suppose that before considering interest expense you have $2 of taxable income subject to a tax
rate of 40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your
taxable income by $0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40
percent = $0.76. By deducting the $0.10 interest expense, you have reduced your tax bill by $0.04.
You pay out the $0.10 and get a benefit of $0.04. In effect, the cost of your debt is not $0.10, but
$0.06 -- $0.04 is the government's subsidy of your debt financing. We can generalize this benefit
from the tax deductibility of interest. Let rd represent the cost of debt per year before considering
the
tax deductibility of interest, r*d represent the cost of
debt after considering tax deductibility of interest, and Example 1: The cost of debt
t be the marginal tax rate. The effective cost of debt Problem
for a year is:
Suppose the Plum Computer Company can issue debt
rd* = rd (1 - t) with a yield of 6 percent. If Plum's marginal tax rate is
40 percent, what is its cost of debt?
$0.10
Using our example, rd = = 10 percent and t = 40 Solution
$1.00
rd = 0.06 (1 − 0.40) = 0.0360 or 3.6 percent
percent and the effective cost of debt is:
rd* = 0.10 (1 - 0.40) = 0.06 or 6 percent per year.
Creditors receive 10 percent, but it

only costs the company 6 percent. Example 2: Cost of debt
In our example, the required rate of Problem

return is easy to figure out: we
Suppose the ABC Company can issue bonds with a face value of
borrow $1, repay $1.10, so your
lender's required rate of return of 10 $1,000, a coupon rate of 5 percent (paid semi-annually), and 10 years to
percent per year. But your cost of maturity at $980 per bond. If the ABC Company’s marginal tax rate is 30
debt capital is 6 percent per year, percent, what is its cost of debt?
less than the required rate of return,
Solution
thanks to Congress. Most debt
financing is not as straight-forward, Given: FV = $1,000; PV = $980; N = 20; PMT = $25
requiring us to figure out the yield
on the debt -- the lender's required rd = 2.5299% x 2 = 5.0598%
rate of return -- given information
r* = 5.0598% (1 - 0.30) = 3.5419%
about interest payments and d
maturity value.
Example 3: The cost of preferred equity

B. The cost of preferred equity
Problem
The cost of preferred equity is the cost associated
with raising one more dollar of capital by issuing Suppose the XYZ Company is advised
shares of preferred stock. Preferred stock is a that if it issues preferred stock with a fixed
perpetual security dividend of
-- it never matures. Consider the typical preferred $4 a share, it will be able to sell these
stock with a fixed dividend rate, where the dividend shares at $50 per share. What is the cost
is expressed as a percentage of the par value of a of preferred stock to XYZ?
share. Solution
The value of preferred equity is the present value of
rp = $4/$50 = 8%
Page |5
all future dividends to be received by the investor. If

a share of preferred stock has a 5 percent dividend
(based on a $100 par value) paid at the end of each
year, the value of the stock today is the present
value of the stream of $5's forever:
Value of preferred equity = P = $5 / cost of preferred stock
C. The cost of common equity
The cost of common equity is the cost of raising one more dollar of common equity capital,
either internally -- from earnings retained in the company -- or externally -- by issuing new shares
of common stock. There are costs associated with both internally and externally generated capital.
How does internally generated capital have a cost? As a company generates funds, some portion
is used to pay off creditors and preferred shareholders. The remaining funds are owned by the
common shareholders. The company may either retain these funds (investing in assets) or pay
them out to the shareholders in the form of cash dividends. Shareholders will require their
company to use retained earnings to generate a return that is at least as large as the return they
could have generated for themselves if they had received as dividends the amount of funds
represented in the retained earnings.
Retained funds are not a free source of capital. There is a cost. The cost of internal equity funds
(i.e., retained earnings) is the opportunity cost of funds of the company's shareholders. This
opportunity cost is what shareholders could earn on these funds for the same level of risk. The
only difference between the costs of internally and externally generated funds is the cost of issuing
new common stock. The cost of internally generated funds is the opportunity cost of those funds
-- what shareholders could have earned on these funds. But the cost of externally generated funds
(that is, funds from selling new shares of stock) includes both the sum of the opportunity cost and
cost of issuing the new stock.
The cost of issuing common stock is difficult to estimate because of the nature of the cash flow
streams to common shareholders. Common shareholders receive their return (on their investment
in the stock) in the form of dividends and the change in the price of the shares they own. The
dividend stream is not fixed, as in the case of preferred stock. How often and how much is paid
as dividends is at the discretion of the board of directors. Therefore, this stream is unknown so it
is difficult to determine its value.
The change in the price of shares is also difficult to estimate; the price of the stock at any future
point in time is influenced by investors' expectations of cash flows farther into the future beyond
Page |6
that point. Nevertheless, there are two methods commonly used to estimate the cost of common
stock: the dividend valuation model and the capital asset pricing model. Each method relies
on different assumptions regarding the cost of equity; each produces different estimates of the
cost of common equity.
Cost of common equity using the dividend valuation model

The dividend valuation model (DVM) states that the price of a share of stock is the present
value of all its future cash dividends, where the future dividends are discounted at the required
rate of return on equity, r. If these dividends are constant forever (similar to the dividends of
preferred stock, we just covered), the cost of common stock is derived from the value of a
perpetuity. However, common stock dividends do not usually remain constant. It's typical for
dividends to grow at a constant rate. Using the dividend valuation model,
P0 = D1 (re - g)
where D1 is next period's dividends, g is the growth rate of dividends per year, and P is the current
stock price per share. Rearranging this equation to solve instead for re,
D
1
re= +g
P0
we see that the cost of common equity is the sum of next period's dividend yield, D 1/P, plus the
growth rate of dividends:
Cost of common equity = Dividend yield + Growth rate of dividends
Consider a company expected to pay a constant dividend of $2 per share per year, forever. If
the company issues stock at $20 a share, the company's cost of common stock is:
re = $2/$20 = 0.10 or 10 percent per year.
But, if dividends are expected to be $2 in the next period and grow at a rate of 3 percent per year,
and the required rate of return is 10 percent per year, the expected price per share (with D 1 = $2
and g = 3 percent) is:
P = $2 / (0.10 - 0.03) = $28.57.
The DVM makes some sense regarding the relation between the cost of equity and the dividend
payments: The greater the current dividend yield, the greater the cost of equity and the greater
the growth in dividends, the greater the cost of equity. However, the DVM has some drawbacks:

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▪ How do you deal with dividends

that do not grow at a constant Example 4: The cost of equity using the DVM
rate? This model does not
Problem
accommodate non- constant
growth easily. Consider the Plum Computer Company that
▪ What if the company does not pay currently pays an annual dividend of $2.00 per
dividends now? In that case, D1 share. Plum's common stock has a current market
would be zero and the expected value of $25 per share. If Plum's annual dividends
price would be zero. But a zero are expected to grow at 5 percent per year, what is
price for stock does not make any its cost of common stock?
sense! And if dividends are
expected in the future, but there Solution
are no current dividends, what do
you do?
▪ What if the growth rate of Given: P = $25; D0 = $2.00; g = 5%
dividends is greater than the D1 = D0 (1 + g) = $2.00 (1 + 0.05) = $2.10
required rate of return? This
implies a negative stock price, re = ( D1/P ) + g = 0.084 + 0.05 = 0.134 or 13.4%
which isn't possible.
▪ What if the stock price is not readily
available, say in the case of a privately-held company? This would require an estimate of
the share price.
Therefore, the DVM may be appropriate to use to determine the cost of equity for companies with
stable dividend policies, but it may not applicable for all companies.
Cost of common equity using the capital asset pricing model
The investor's required rate of return is compensation for both the time value of money and risk.
To figure out how much compensation there should be for risk, we first have to understand what
risk we are talking about. The capital asset pricing model (CAPM) assumes an investor holds
a diversified portfolio -- a collection of investments whose returns are not in synch with one
another. The returns on the assets in a diversified portfolio do not move in the same direction at
the same time by the same amount. The result is that the only risk left in the portfolio is the risk
related to movements in the market as a whole (i.e., market risk).
If investors hold diversified portfolios, the only risk they have is market risk. Investors are risk
averse, meaning they don't like risk, so if they are going to take on risk they want to be
compensated for it. Investors who only bear market risk need only be compensated for market
risk. If we assume all shareholders' hold diversified portfolios, the risk that is relevant in the valuing
a particular investment is the market risk of that investment. It is this market risk that determines
the investment's price. The greater the market risk, the greater the compensation -- meaning a
higher yield -- for bearing this risk. And the greater the yield, the lower the present value of the
asset because expected future cash flows are discounted at a higher rate that reflects the higher
risk.
The cost of common equity, estimated using the CAPM, is the sum of the investor's compensation
for the time value of money and the investor's compensation for the market risk of the stock:

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Let's represent the compensation for the time value of money as the expected risk-free rate of
interest, rf. If a particular common stock has market risk that is the same as the risk of the market
as a whole, then the compensation for that stock's market risk is the market risk premium. The
market's risk premium is the difference between the expected return on the market, rm, and the
expected risk-free rate, rf:
re = rf + (rm - rf)
where rf is the expected risk free rate of interest, Example 5: The cost of equity using the CAPM
is a measure of the company's stock return to
changes in the market's return (beta), and rm is Problem
the expected return on the market. The Plum Computer Company's common stock has an
The CAPM is based on two ideas that make sense: estimated beta of 1.5. If the expected risk−free rate of
investors are risk averse and they hold interest is 3 percent and the expected return on the
diversified portfolios. But the CAPM is not market is 9 percent, what is the cost of common stock
without its drawbacks. First, the estimates rely for Plum Computer Company?
heavily on historical values -- returns on the Solution
stock and returns on the market. These
historical values may not be representative of Given: rf = 3%; rm = 9%;  = 1.5
the future, which is what we are trying to gauge. re = rf + (rm − rf)
Also, the sensitivity of a company's stock
returns may change over time; for example, re = 3% + 1.5 (9% − 3%) = 12%
when the company changes its capital
structure.
Second, if the company's stock is not publicly-traded, there is no source for even historical values.
Calculating the weighted average cost of capital

The cost of capital is the average of the cost of each source, weighted by its proportion of the total capital
it represents. Hence, it is also referred to as the weighted average cost of capital (WACC) or the
weighted cost of capital (WCC). The weighted average cost of capital is:
WACC = wdr d* + wprp + were
where
wd is the proportion of debt in the capital structure;

wp is the proportion of preferred stock in the capital
structure; and
we is the proportion of common stock in the capital structure.

Page |9
As you raise more and more money, the cost of each additional dollar of new capital may increase.
This may be due to a couple of factors: the flotation costs and the demand for the security
representing the capital to be raised.
As you raise more and more money, the cost

Example 6: Calculating the WACC
of each additional dollar of new capital may
increase. This may be due to a couple of Problem
factors: the flotation costs and the demand for
the security representing the capital to be Consider the Plum Computer Company once again. Suppose
raised. For example, the cost of internal funds Plum will raise capital in the following proportions: Debt: 40
from retained earnings will differ from the cost percent; Preferred stock: 10 percent; Common stock: 50
percent. What is Plum's weighted average cost of capital if its
of funds from issuing common stock due to
cost of debt is 3.6 percent, its cost of preferred stock is 8
flotation costs. If a company expects to
percent, and its cost of common stock is 12 percent?
generate $1,000,000 entirely from what's
available in internal funds -- retained earnings Solution
-- there are no flotation costs. But if the
company needs $1,000,001, that $1 above WACC = 0.40 (0.036) + 0.10 (0.08) + 0.50 (0.12)
$1,000,000 will have to be raised externally, WACC = 0.0144 + 0.008 + 0.06
requiring flotation costs.
WACC = 0.0824 or 8.24%
Additional capital may be more costly since the
company must offer higher yields to entice
investors to purchase ever larger issues of securities. Considering the effects of flotation costs
and the additional yield necessary to entice investors, we most likely face a schedule of marginal
costs of debt capital and a schedule of marginal costs of equity capital. Hence, we need to
determine at what level of raising funds the marginal cost of capital for the company changes.

P a g e | 10
WHAT IS CAPM?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the
expected return and risk of investing in a security. It shows that the expected return on a security
is equal to the risk-free return plus a risk premium, which is based on the beta of that security.
Below is an illustration of the CAPM concept.
BETA – The Capital Asset Pricing Model (CAPM)
Many investors hold more than one financial asset. A portion of a security’s risk called
unsystematic risk can be controlled through diversification. This type of risk is unique to a given
security business, liquidity and default risks, fall on this category. Non-diversifiable risk, more
commonly referred to as systematic risk, results from forces outside of the firms’ control and are
therefore not unique to the given security. Purchasing power, interest rate and market risks fall
into this category. This type of risk is measured by BETA.
Beta (b) measures a security’s volatility relative to an average security. A particular

share’s beta is useful in predicting how much a security will go up or down, provided that you
know which way the market will go. It does help you to figure out risk ad expected return.
How to Read a Beta?

Here is how to read betas:
Beta Meaning
1 The security’s return is independent of the market. An example is a risk-free security.
0.5 The security is half as volatile as the market.

1.0 The security is as volatile or risky as the market (average risk).
2.0 The security is twice as volatile or risky as the market.
Beta is a measure of a security’s return over time to that o the overall market. For
example, if your business enterprise’s beta is 2.0, it means that if the share capital market goes
up 10%, your business enterprise ordinary share goes up 20%; if the market goes down 10%,
your business enterprise share capital price goes down 20%.
Levered and Unlevered Beta

Levered Beta takes debt and equity in its capital structure and then compares the risk of
a firm to the volatility of the market; while Unlevered Beta takes only equity in its capital
structure and then compares the risk of a firm to the risk of the market. Unlevered beta is useful
when comparing companies with different capital structures as it focuses on the equity risk.

P a g e | 11
The formula for levered beta is:
BL= BU (1 + (1-t) (D/E))

Where: BL Beta Levered
BU Beta Unlevered
t Corporate Tax
D Market value of Debt (usually the book value of debt)
E Market value of Equity (Market Cap).
Some companies have high level of debt on their balance sheet. This leverage makes
their earnings volatile and investment in this company becomes risky. Levered beta considers
the risk of leverage and its impact on company’s performance. So, levered beta is not an ideal
measure to compare two companies with different debt proportions. In this scenario, you will
have to remove the effect of debt by “unlevering” the beta. Unlevered beta will facilitate a better
comparison for such companies than levered beta.
The formula for unlevered beta is:
Let’s take the following unlevered beta example:

Company XYZ is a non-listed private company with the following details:
Total Debt Php 2 million Total Equity Php 5 Million

Debt to Equity ratio 40% Tax rate 30%
We will find out the beta for the Company XYZ.
Step 1
We have to find out a comparable company which is similar in nature to the Company XYZ.
The comparable company must be publicly listed so that its beta can be calculated.
We have Company ABC which has very similar in nature with Company XYZ. Company
ABC is operating in the same industry and it has the same product line and risk profile as
Company XYZ. The following are details of Company ABC:
Calculated Beta 1.2 Total Equity Php 8 Million

Total Debt Php 4 million Debt to Equity ratio 50%
Tax rate 35%

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Step 2
Calculate the beta of the comparable company. Company ABC has a beta of 1.2. We will
have to unlever the beta of Company ABC which means that we have to remove the effect of
leverage from the beta of company ABC.
To compute:
Unlevered Beta (βCompany ABC) = Levered beta (βCompany A)

—————————-----------
1 + [ (1- Tax) (Debt/Equity) ]
Unlevered Beta (βCompany ABC) = 1.2

———————–
1 + [ (1- 0.35) (0.5) ] = 0.91
Last Step
Adjust Company ABC’s (comparable company) unlevered beta for the capital structure of
Company XYZ. We will assume that the unlevered beta of Company ABC is the same as
Company XYZ because they are similar in nature. By adjusting the unlevered beta of Company
XYZ for its leverage, we will find the beta of Company XYZ as follows:
Levered beta (βCompany XYZ) = Unlevered Beta (Company XYZ) x 1 + [(1- Tax) (Debt/Equity)]
Levered beta (βCompany X) = 0.91 x 1 + [ (1- 0.3) (0.4) ]

= 1.17
In this illustration Company XYZ has a beta of 1.17
What is the Market Risk Premium? (corporatefinanceinstitute.com)

Market risk premium is the additional return that an investor will receive (or expects to
receive) from holding a risky market portfolio instead of risk-free assets. At the center of the
CAPM is the concept of risk (volatility of returns) and reward (rate of returns). Investors always
prefer to have the highest possible rate of return combined with the lowest possible volatility of
returns.

P a g e | 13
The Market Risk Premium formula is:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate
Example:
The S&P 500 generated a return of 8% the previous year, and the current interest rate of the
Treasury bill is 4%. The premium is 8% – 4% = 4%.
The Capital Asset Pricing Model (CAPM) Calculation

Under CAPM, there is a relationship between a share’s expected/required return and its
beta. The following is the formula:
rj = rt + b (rm – rt)

P a g e | 14
Example:
Assume that the risk-free rate is 6% and the expected return on a market portfolio is 10%. If
a share has a beta of 2.0, what is the risk premium? To calculate:
= 6% + 2.0 (10% - 6%)
= 6% + 8%
= 14%
This means that you would expect or demand an extra 8% (risk premium) on this share on
top of the risk-free premium of 6%. Hence, the total required return should be 14%.
Arbitrage Pricing Theory Model (source: Investopedia)

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea
that an asset's returns can be predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that capture systematic risk. It is a
useful tool for analyzing portfolios from a value investing perspective, in order to identify
securities that may be temporarily mispriced.
The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as
an alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume
markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the
market eventually corrects and securities move back to fair value. Using APT, arbitrageurs hope
to take advantage of any deviations from fair market value.
The formula for the Arbitrage Pricing Theory Model is:

E(R)i = E(R)z + (E(I) − E(R)z) × βn
where:
E(R)i = Expected return on the asset

Rz = Risk-free rate of return
Βn = Sensitivity of the asset price to macroeconomic factor n
Ei = Risk premium associated with factor i
Using the following example, let’s compute the expected return on the asset using the APT
model formula:
• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Standard and Poor's 500 index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%

P a g e | 15
Using the APT formula, the expected return is calculated as:

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%
Constant (Gordon) Growth Model (source: Investopedia)

The Gordon Growth Model (named after Myron Gordon) values a company's stock using
an assumption of constant growth in payments a company makes to its common equity
shareholders. The three key inputs in the model are dividends per share (DPS), the growth rate
in dividends per share, and the required rate of return (RoR).
Dividends per share represent the annual payments a company makes to its common
equity shareholders, while the growth rate in dividends per share is how much the rate of
dividends per share increases from one year to another. The required rate of return is a
minimum rate of return investors are willing to accept when buying a company's stock, and
there are multiple models investors use to estimate this rate.
Formula and Calculation of the Gordon Growth Model:
D1
P = (r – g)
where:
P = Current stock price

G = Constant growth rate expected for dividends, in perpetuity
R = Constant cost of equity capital for the company (or rate of return)
D1= Value of next year’s dividends
Example:
Consider a company whose stock is trading at P110 per share. This company requires an
8% minimum rate of return (r) and will pay a P3 dividend per share next year (D1), which is
expected to increase by 5% annually (g).
The intrinsic value (P) of the stock is calculated as follows:
P3,00
P = (.08-.05) P = P100.00
According to the Gordon Growth Model, the shares are currently P10 overvalued in the
market.

P a g e | 16
Summary
The cost of capital is the marginal cost of raising additional funds. This cost is important in our
investment decision making because we ultimately want to compare the cost of funds with the
benefits from investing these funds. The cost of capital is determined in three steps: (1) determine
what proportions of each source of capital we intend to use; (2) calculate the cost of each source
of capital, and (3) put the cost and the proportions together to determine the weighted average
cost of capital.
The required rate of return on debt is the yield demanded by investors to compensate them for
the time value of money and the risk they bear in lending their money. The cost of debt to the
company differs from this required rate of return due to flotation costs and the tax benefit from the
deductibility of interest expense. The required rate of return on preferred stock is the yield
demanded by investors and differs from the company's cost of preferred equity because of the
costs of issuing additional shares (the flotation costs).
The cost pf common equity is more difficult to estimate than the cost of debt or preferred stock
because of the nature of the return on stock: Dividends are not guaranteed nor fixed in amount,
and part of the return is from the change in the value of the stock. The dividend valuation model
and the capital asset pricing model are two methods commonly used to estimate the required rate
of return on common equity. The DVM deals with the expected dividend yield and is based on an
assumption that dividends grow at some constant rate into the future. The CAPM assumes that
investors hold diversified portfolios, so they require compensation for the time value of money and
the market risk they bear by owning the stock.
The proportion of each source of capital that we use in calculating the cost of capital is based
on what proportions we expect the company to raise new capital. If the company already has a
capital structure -- a mix of debt and equity it feels appropriate -- then that same proportion of
each source of capital, in market value terms, is a good estimate of the proportions of new
capital.
The cost of capital is the cost of raising new capital. The weighted average cost of capital is the
cost of all new capital for a given level of financing. The cost of capital is a marginal cost -- the
cost of an additional dollar of new capital at a given level of financing.
In determining the optimal amount to spend on investments, the relevant cost is the marginal
cost, since we are interested in investing until the marginal cost of the funds is equal to the
marginal benefit from our investment. The point where marginal cost = marginal benefit results
in the optimal capital budget.
The actual estimation of the cost of capital for a company requires a bit of educated guesswork,
and lots of reasonable assumptions. Using readily available financial data, we can, at least,
arrive at a good enough estimate of the cost of capital.
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UNIT 4. DISCOUNTED CASH FLOW METHOD
In Financial Management, it has been discussed that a way to determine the value of an
investment opportunity is by determining the actual cash generated by a particular asset.
Recall that discounted cash flows analysis can be done by determining the present value
of the net cash flows of the investment opportunity in Conceptual Framework and
Accounting Standards, it was discussed that the cash flows are presented and analyzed
based on their sources and activities which are categorized as operating, investing and
financing in determining the value of an asset, the cash flows are important reference or
inputs. In determining the value of the asset, it is essential to include amount of cash that
will be available for the claims of the equity owners.
The Net Cash Flows refer to the amount of cash available for distribution to both debt
and equity claims of the business or asset. This is calculated from the net cash generated
from operations and for investment over time. For GCBO, the net cash flows generated
will be based on the cash flows from operating and investing activities, since this
represents already the amount earned or will be earned from the business and the amount
that is required to be infused in the operations to generate more profit
Net Cash Flows is preferred as basis of valuation if any of the following conditions are
present
• Company does not pay dividends
• Company pays dividends but the amount paid out significantly differs from its
capacity to pay dividends
• Net Cash Flows and profits are aligned within a reasonable forecast period
• Investor has a control perspective. If an investor can exert control over a company,
dividends can be adjusted based on the decision of the controlling investor.
Using net cash flows over other cash flow concepts is more advantageous in a valuation
activity since this metric can be directly used as input to a DCF model. This is not the
case for other cash flow or earnings measure such as EBITDA, EBIT, net income and
cash flow from operations since these metrics might have missed or double counted an
item.
• EBITDA and EBIT are both metrics that are before taxes: cash flows that are
available to investors should be after satisfying tax requirements of the government
• EBITDA and EBIT also do not consider differences in capital structures since it
does not capture interest payments, dividends for preference shares and funds
sourced from bondholders to fund additional investments
• All these measures also do not consider reinvestment of cash flows made into the
firm for additional working capital and fixed assets investment that are necessary
to maximize long-term stability of the business
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In valuation, analysts find analyzing cash flows and its sources helpful in
understanding the following:
• Source of financing for needed investments - Are investments internally
funded by cash generated from operations or debt/equity financing is
necessary? The best case for firms is to fund its investments wholly or partly
through cash from operations. Heavy reliance on external financing from
lenders or shareholders may signal that cash from operations is not enough to
support the firm's long-term stability.
• Reliance on debt financing - Debt financing is an excellent financing strategy
especially for expanding companies. However, it can become a problem for a
firm if its cash from operations is insufficient to repay existing debt obligations.
The situation worsens if firms continuously refinance borrowings that come due
by another borrowing.
• Quality of earnings- Significant disparities between cash flows and income
may indicate earnings does not get converted to cash easily suggesting low
quality.
There are two levels of Net Cash Flows:
(1) Net Cash Flows to the Firm; and
(2) Net Cash Flows to Equity.
The Net Cash Flows to the Firm is the amount made available to both debt and equity
claims against the company.
The Net Cash Flows to Equity represents the amount of cash flows made available to the
equity stockholders after deducting the net debt or the outstanding liabilities to the
creditors less available cash balance of the company.
The net cash flows can be determined by referring to the financial statements of the
company.
Net Cash Flow to the Firm

Net cash flow to the firm refers to the cash flow available to the parties who supplied
capital (i.e. lenders and shareholders) after paying all operating expenses, including
taxes, and investing in capital expenditures and working capital as required by business
needs. NCF to the firm is cash flows generated from operating activities of the business
which is intended to pay required return of fund providers. Valuation models based on
enterprise value encompass cash flows available to all investors - whether debt or equity.
Enterprise value of a company refers to the theoretical value of its core business activities
as reflected by its net cash flows This is the basic premise of most corporate valuation
methodologies.
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Net cash flow only capture items that are directly related to the operating and investing
activities of the business. Consequently, net cash flow excludes items associated with
financing activities. Net cash flows to the firm can be computed or derived using the
following approaches.
A. Based from Net Income (or indirect approach)
Net Income Available to Common shareholders Php xxx

Add: Non Cash Charges (net) xxx
Add: Interest Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital (Purchases - Sales of Fixed xxx
Capital Investment)
Net Cash Flows to the Firm Php xxx
• Net Income Available To Common Shareholders
Basic measure of a firm's profitability which refers to the bottom line figure in an
income statement. This is the amount left for the common shareholders after
deducting all costs, expenses, depreciation, amortization, interest, taxes and
dividends to preferred shareholders
This is an accounting measure, meaning that non-cash items like depreciation and
amortization is also included as a deduction to arrive at net income. However, this
measure does not include changes in working capital nor capital investments made
during the specific period which significantly affects a firm's cash flows.
• Non-Cash Charges (Net)
Pertains to non-cash items that are included in the computation of net income.
Analyst usually look at the statement of cash flows to validate potential non-cash
charges. If amount in the income statement does not match amount reflected in
the cash flows statement, it can be indicative that a portion of that expense is non-
cash, the common non-cash items are the following:
o Depreciation and amortization
When a firm acquires a fixed asset like equipment or intangible asset, the
initial cash outflow is made at point of acquisition and is presented in the
balance sheet. In succeeding periods, a portion of the initial cash outflow is
recorded as depreciation and amortization which reduces net income,
despite not having an actual cash outflow. As a result, this should be added
back to arrive at the real cash flow.
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o Restructuring charges
Restructuring refers to the change in the organizational structure or

business model of a company adapt to changing economic climate or
business needs. Most restructuring involves involuntary separation of
employees. As a result, the restructuring requires the company to pay them
severance pay. Severance pay should comply with the minimum
requirements set in the Labor Code of the Philippines. Severance pays are
normally outright cash outflows.
The company may also need to record write-down in value of pension

assets (or reversal of previous accruals) as a result of the restructuring
activity. This is usually recorded as part of the restructuring expenses
(income) in the income statement. However, since there are no cash outlays
involved in write downs (reversal gains), this should be added back to
(deducted from) net income to get NCF.
o Provisions for Doubtful Accounts
These are estimated amount to be incurred for the customers inability to

pay on time which is cumulatively accounted under the statement of
financial position reported against the accounts receivable. Since these
amounts represent the value that may have high probability of collection but
not yet written off, meaning there is a positive chance that it can still be
collected then it should be added back to the net income attributable to
common.
o After-Tax Interest Expense (net of any tax savings)
This interest expense is a cash flow intended for the debt providers In the
Philippines, interest expense is a tax-deductible expense for the company
This means that when the company pays interest, it reduces tax to be paid.
Hence, the cash outflow is the amount of interest expense less any tax
savings.
After-tax interest expense is added back to net income since the objective
of NCF is to measure the cash flows associated with the operating activity
of the business. The impact of financing should be neutralized to arrive at
the real business value based on its operations.
Page |5
o Working Capital Adjustment
Also known as working capital, this item represents the net investment in
current assets such as receivables and inventory reduced by current
liabilities like payables. The amount captured is based on the movements
in these accounts from prior year.
Required investment in current assets tend to increase when a firm's sales

grow consistently year on year. Higher receivables and inventories are
needed in order to support rising revenues. The company also needs higher
financing through accounts payable or taxes payable to fund these
receivables and inventories Increase in current assets means cash outflow
while higher current liabilities are cash inflows Otherwise, the company may
miss out on sales growth if they lack the current assets and liabilities to
support it. Fast growing firms engaged in industries with high working capital
needs like retailing and manufacturing tend to have substantial rise in
working capital Companies do not need to pay for taxes when they are
investing in their operating capital. On the other hand, if current assets
requirement decline, this means that more cash is available to debt and
equity providers, thus, added back
For NCF and valuation purposes, movements in cash, marketable

securities short-term notes payable and current portion of long-term debt is
excluded in the computation. Cash is excluded since the purpose of the
NCF exercise is to identify what is the real cash flow of the business
Marketable securities are also excluded since these are not directly linked
to operations. On the other hand, notes payable and current portion of long-
term debt are excluded since they are associated with the financing side of
the business.
• Investment in Fixed Capital
Pertains to cash outflows made to purchase or pay for capital expenditures that
are required to support existing and future operating needs. Capital expenditures
range from property, plant and equipment necessary for production requirements
to intangible assets like trademark, patent and copyrights. Firms expect that they
will reap benefits for more than one year as a result of these investments. The
investment in fixed capital assumes that the projects financed acceptable and has
positive net present value.
Increases in fixed capital investments use cash, hence, a reduction to Net Cash
Flow. This is captured in the year that the cash outflow is made, Information related
to these can be found in the balance sheet and statement of cash flows. Once
Page |6
initial cash payment is made, this is charged to succeeding year's income

statement as depreciation and amortization. Treatment for depreciation and
amortization applies.
When gaps exist between amount of capital investment and depreciation (called
as net capital expenditures), this is usual related to the growth profile of the
company. Company expecting high growth tend to report high net capital
expenditures compared to earnings while low-growth companies usually have
negative net capital expenditures.
Cash paid for acquisition of a new business also falls into this category. The full
purchase amount reduces the Net Cash Flow in the year of acquisition. If the
acquisition involves non-cash settlement, analysts should be careful in capturing
only portion denominated in cash as reduction to Net Cash Flows.
On the other hand, if there are sale of capital expenditures that occurred, this
should be added back to the Net Cash Flow. This sales increase the cash inflow
which consequently reduces the investment in fixed capital for that period. For
example, if a property is sold for Php 1,000,000, then this should reduce the
amount of investment in fixed capital (i.e. ultimately, an addition to net cash flows).
Hence, net investment in fixed capital is deducted to arrive at Net Cash Flow
computation. A negative net investment signifies that firm received cash since it
sold more assets than it purchased for the year.
Analyst should use the statement of cash flows to analyze cash flows related to
fixed capital investments. There are instances when companies may obtain fixed
capital in exchange of shares which doesn't necessarily have impact to cash flows
Even though transactions might be non-cash for the current year, analysts should
be careful in forecasting future fixed capital investments especially if it will require
cash outlays
B. From Statement of Cash Flows
NCF can also be computed using cash flows from operating activities in the statement
of cash flows) as the starting point Analysts usually start from this item since it already
considers adjustment for noncash expenses and working capital investments.
As a refresher, the statement of cash flows classifies cash flow into three major
sections: cash flow from operating activities, cash flow from investing activities and
cash flow from financing activities.
Page |7
Cash Flows from Operating Activities Php xxx

Add: Interest Expense (net of Taxes)* xxx
Less Cash Flows from Investing Activities xxx
*only if deducted from the operations
• Cash flow from operating activities
This represents how much cash the company generated from its operations. This
shows how much cash is received from customers and how much cash outflows
are paid to vendors. This also captures changes in current assets and current
liabilities Normally, this is computed from net income by considering non-cash
items and working capital changes. This is considered in computing for NCFF.
• Cash flow from investing activities
This represents how much cash is disbursed (received) for investments in (sale of)
long-term assets like property, plant and equipment and strategic investments in
other companies. This is considered in computing for NCFF. If this section reflects
transactions involving financial assets, this should be excluded.
• Cash flow from financing activities
This represents how much cash was raised (or repaid) to finance the company
This is not considered when computing NCFF This is simply because these figures
will be accounted for in the calculation of the Net Cash Flows to the Equity.
Analysts should be mindful how interest and dividends are classified in the
statement of cash flows. IFRS allows interest and dividends received to be
classified under operating or investing activities while interest and dividends paid
out is placed under operating or financing activities. One-time or extraordinary
items should also be eliminated from the computation.
Page |8
C. From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
EBITDA, net of Taxes Php xxx

Add: Tax Savings on Noncash Charges xxx
Add / Less: Working Capital Adjustments xxx
Less: Investment in Fixed Capital xxx
• EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization

pertains to income before deducting interest, taxes, depreciation and amortization
expenses, net of taxes.
Since the basis of the computation for the NCFF is already the earnings after
excluding the financing costs, taxes and other non-cash charges, the NCFF should
only consider the amount net of the applicable taxes to be paid. This to
conservatively show the EBITDA at the amount net to be realized by the investor.
• Tax Savings on Non-cash Charges.
Non-cash charges are not typically adjusted if NCFF starts with EBITDA. However,
it is important that analyst should check whether non-cash charges were already
deducted in computing for EBITDA or not. If deducted, then there is a need to add
the item back. If non-cash charges are not yet deducted from EBITDA, there is no
need to add it back to compute for NCFF.
Instead of adjusting for the full amount, analyst should add back the corresponding
tax savings related to this non-cash charges to EBITDA. Several non-cash charges
such as depreciation and amortization are tax-deductible. This means that
occurrence of these expenses reduces the taxes that the company should pay.
thus, reducing cash outflow This is added back to EBITDA to capture this impact.
Concepts on investments in fixed and working capital is same as previous

discussion.
Page |9
Net Cash Flow to Equity

Net Cash Flow to Equity or NCFE refers to cash available for common equity participants
or shareholders only after paying operating expenses, satisfying operating and fixed
capital requirements and settling cash flow transactions involving debt providers and
preferred shareholders.
NCFE can be computed from NCFF by considering items related to lenders and preferred
shareholders NCFE signifies the level of available cash that a business can freely declare
as dividends to its common shareholders. This may still differ significantly from the
dividends actually declared and paid out since this decision is made upon the discretion
of a company's board of directors Companies tend to manage their dividend policy some
slowly increase dividends over time while some maintain current dividends despite actual
profitability. As a result, dividend trend is seen as less volatile compared to earnings as
this is managed by the board of directors.

Add. Proceeds from Borrowings xxx
Less Debt Service xxx
Add Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxx
• Proceeds from Borrowings
This refers to the amount of cash received by the company as a result of borrowing
of long-term debt. Since NCFF did not include items related to financing, it did not
capture cash received by the company from lenders Since the cash from the
borrowing is with the company already, it is added back to NCFF and forms part
of the cash flow available to common shareholders.
• Debt Service
Debt Service is the total amount used to service the loans or debt financing. This
is the total amount of loan repayment and the interest expenses, net of income tax
benefit.
The interest expense is considered as part of the financing activities and hence
deducted from Net Cash Flow since this is associated with long term debt of the
company. The amount to be included must exclude the equivalent tax benefits from
the interest. The tax benefit must accord with what was allowed by the tax regime
P a g e | 10
where the business operates. Please note that this amount must be similar should
an adjustment was made to compute for the NCFF.
• Proceeds from Issuance of Preferred Shares
Same with the debt, preferred shares as another form of financing, other than the
issuance of ordinary equity, must also be factored in the calculation of the net cash
flows available to equity.
• Dividends on Preferred Shares
Since payments made to preferential shareholders in the form of dividends are

outflows. This must be incorporated in the calculation as a reduction of the net
cash flows to equity.
Similarly, given the above formula as guiding principle, NCFE can be determined under
the following approaches:
A. Based from Net Income (or indirect approach)
Net Income Available to Common shareholders Php xxx

Add: Non Cash Charges (net) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital
(Purchases - Sales of Fixed Capital Investment) xxx
Net Cash Flows to the Firm xxx
Add: Proceeds from Borrowing xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
P a g e | 11
B. From Statement of Cash Flows
Cash Flows from Operating Activities Php xxx

Less: Cash Flows from Investing Activities xxx
C. From Earnings Before Interest, Taxes, Depreciation and Amortization

(EBITDA)
EBITDA, net of Taxes Php xxx

Add: Tax savings on Noncash Charges xxx
Add / Less: Working Capital Adjustments xxx
Less: Investment in Fixed Capital xxx
P a g e | 12
Terminal Value
Since GCBOs is assumed to operate in a long period of time to almost perpetuity,

the risk and returns are inherent to the opportunity at the end of the projection
period should also be quantified. Furthermore, the economic value that will be
generated by the assets is expected to be stable after some point in time since the
projections are reliant on certain assumptions made. The challenge for the
determination of the value of the asset is to also account for the economic returns
that it will generate in perpetuity. This is addressed by the Terminal Value.
Terminal Value represents the value of the company in perpetuity or in a going

concern environment. In practice, there are several ways on how to determine the
terminal value.
Basis of Terminal Value
1. Liquidation Value
Some Analysts find that the terminal value be based on the estimated salvage
value of the assets.
2. Estimated Perpetual Value
Another way to determine the terminal value by using the farthest cash flows
you can estimate divided by the cost of capital less growth rate.
𝐶𝐹𝑛+1
𝑇𝑉 =
𝑟−𝑔
Where:
TV = Terminal Value
CFn+1 = Farthest net cash flows
r = cost of capital
g = growth rate
P a g e | 13
For example, a Filipino company is expecting for 15% returns for a venture and
assumes that their net cash flows for the next five years are as follows:
Year Net Cash Flows (in million Php)

1 5.00
2 5.50
3 6.05
4 6.66
5 7.32
In the given illustration, you may note that the net cash flows are growing annually.
Assuming this is a GCBO, and it is expected that the net cash flows will behave on a
normal trend. The growth rate (g) is computed using compounded annual growth rate
formula:
1
𝑁𝐶𝐹𝑛
𝑔= [( ) 0𝑁−1 ] – 1 x 100%
𝑁𝐶𝐹0
Where:
NCF0 = net cash flows at the beginning
NCFn = latest net cash flows
N = latest time
P a g e | 14
Since the growth rate is 10%, it will be applied on the farthest cash flows i.e on the 5 th
year equivalent to P 7.32, thus the farthest cash flows is now P 8.05 or will substitute
the CFn+1. It is now assumed that the cash flows will continuously growth at the rate of
10% per annum. Thus, the formula can now be applied.
𝐶𝐹𝑛+1
𝑇𝑉 =
𝑟−𝑔
8.05
𝑇𝑉 =
15% − 10%
8.05
𝑇𝑉 =
5%
𝑇𝑉 = 𝑃ℎ𝑝 161
3. Constant Growth
Challenges for some valuators is to determine the amount of required return

for a specific type of asset or investment. In lieu of the required return, they use
the growth rate as the proxy especially if the growth is constant and significant.
4. Scientific Estimates
Other valuators especially those with vast experience already in some types
of investments uses other basis for them to determine the reasonable terminal
value. Using guesstimates is not prevented because in the end, equity values
will still be based on negotiation.
There is no perfect approach to determine the terminal value. Actually, some risk averse
investors don't consider the terminal value in their valuation. The differences in their
appreciation on the determination or even the inclusion of the terminal value is dependent
on their risk appetite. Then again, the valuation method will only serve as a reference to
determine the reasonable value for the equity or the asset being purchased. This is why
negotiation plays a key role in finalizing the determined value.
P a g e | 15
Other inputs in the Net Cash Flows

The present value of the Net Cash Flows represents the value of the assets. It may be
recalled further that the assets are financed by debt and equity. Hence, these are the
claims which are presented at the right side of the Statement of Financial Position, under
an account form of reporting.
The discounted cash flows analysis factors in all the projected stream of cash flows that
the project, opportunity or investment and valuing it in present time to determine whether
the investment made on this year would be less than the value it will generate in the
future, that means the investment yielded an amount sufficient to cover the investment
and allowing the investors to earn more. Same principle applies that the best opportunity
is the one that will yield the highest present value or solely if the opportunity will result
into a positive amount it should be accepted Conservatively, the total outstanding
liabilities must be considered and deducted versus the asset value to determine the
amount appropriated to the equity shareholders. This is called the equity value. The
opportunity that will result in the highest equity value is considered.
DCF Analysis is most applicable to use when the following are available:
• Validated Operational and Financial Information.
• Reasonable appropriated cost of capital or required rate of return
• New quantifiable information
Illustrative Example No.1
Bagets Corporation has projected to generate revenues, cash operating expenses, and
the corresponding tax payments for the next five years:
Revenue Cash Operating Taxes Working Capital Debt Service

Expenses Adjustments
1 92.88 65.02 45.57 18.58 14.03
2 97.52 68.26 48.23 19.50 14.32
3 102.40 71.68 51.04 20.48 14.65
4 107.52 75.26 54.01 21.50 15.00
5 112.90 79.03 57.15 22.58 15.40
The investment in fixed capital that was purchased and invested in the company
amounted to Php100 Million. To be financed by
• 60% from loan borrowing with an annual interest of 10% payable equally in five
years. First payment will be due after 1 year, and
• 10% preferred shares with 8% coupon rate
P a g e | 16
If you are going to purchase 50% of Bagets Corporation, assuming a 15% required
return, how much would you be willing to pay?
Based on the foregoing information, the value of Bagets Corporation equity is Php22.80
Million. If the amount at stake is only 50% then the amount to be paid is Php11.4 Million
(Php22 80 x 50%).
P a g e | 17
Financial Models in Discounted Cash Flows Analysis
Financial Modelling is a sophisticated and confidential activity in a company or for an

analyst. Information can also be considered as competitive advantage of a company or a
person. Most of the companies hire financial modelers to assist them in determining the
value of GCBOs or other opportunities. They also ask them to validate ballpark estimates
and may also be used to determine impairments. Most financial modelers have extensive
financial acumen and vast knowledge and experience. Financial modelers normally are
economists, financial managers, and accountants. Management accountants are good
candidate for this role given their ability to understand operational models and design long
term financial strategies order to develop financial models, the following steps needs to
be observed
1. Gather historical information and references
Historical information must be made available before the financial model is to be

constructed Historical information may be generated from, but not limited to the
following audited financial statements, corporate disclosures, contracts and peer
information.
Audited Financial Statements are the most ideal reference for the historical
performance of the company. The components of the Audited Financial Statements
enable the analyst or the financial modeler to assess the future of the company based
on its past performance. Statement of Income are used to determine the historical
financial performance, Statement of Financial Position is used to determine the book
value of the assets and the disclosed stakes of the debt and equity financiers,
Statement of Cash Flows illustrate how the company historically financing its
operations and investments. Statement of Changes in Stockholder's Equity provides
the information on how much is the claim and dividend background of the company
One of the most important components of the financial statements are the Notes to
the Financial Statements. It provides the summary of important disclosure that should
be considered in the valuation. The financial modeler must be able to quantify these
disclosures and more importantly the risks involved.
Corporate disclosures are also key in developing the financial model Corporate
disclosures provide more context for the future plans and strategies of the company.
This will enable the analysts or the financial modelers to identify the risks about the
GCBO and quantify them accordingly. Since these are available to the public, it is the
same information that is known to others. The difference among modelers is their
personal appreciation to risk and their client's appetite for risks.
P a g e | 18
Contracts are formal agreements between parties. In valuing the GCBOs, it IS

important for the modeler to also know the existing contracts and the covenants
contained in it, Large accounting firms offer transaction advisory services to assist
their clients who enter into new ventures Due diligence is necessary to verify any
contingent liability and other legal risks surrounding that opportunity and quantify it
accordingly to have a more conservative value. The modeler must be able to classify
the probability of these from occurring Gathering this information is important to have
a reasonable basis to quantify and incorporate it in the financial model.
Peer information and other public information are also essential inputs to the financial
model Peer information provides more context and even supports the risks identified
or will be assumed in the valuation process. Peers may be other analyst’s industry
experts and other consultants. Internal members of the organization may also be
considered as peers. However, the information sharing is restricted by law since these
are insider information and is not a for the public Researches and studies can also
be used as peer information.
In the Philippines reliable sources could be the National Library and Philippine
institute on Development Studies Researches and studies shared through
conventions and forums will also be relevant inputs in the development of the financial
model and in valuation.
Collectively the financial model must be able to filter the information that would be
necessary for the valuation Relevance and reliability of information are important Not
all information should be given consideration.
Materiality is another consideration Even if there are additional information gathered

there should be a sense of materiality assessment involved Note that projections
remain to be estimates. Therefore, only relevant items should be considered in the
valuation.
2. Establish drivers for growth and assumptions
Once all relevant information was gathered and validated divers and assumptions can
be established by conducting financial analysis. Drivers are suggested to be those
validated and is represented by authorities like government or experts. Growth drivers
are normally based on population since most of the businesses are consumer goods
of services industry growth may be used as a driver. In the Philippines information is
available from the Philippine Statistics Authority Because the government needs to
be transparent to its citizens it fortunate that the information can be found in the
government website or is disclosed to public through media with wider reach and
scale.
P a g e | 19
For other economic factors, drivers, and estimates, Bangko Sentral ng Pilipinas and
National Economic and Development Authority are also other agencies that can be
relied with. Certain statistical information can also be found from the websites or
research centers of the Local Government Units and National Government Agencies.
Research organizations may also be used, however, strong validation and evaluation
needs to be done to isolate any form of biases that may affect value.
The usual growth indicators used are: inflation, population growth, GNP or GDP
growth. In economics, the inflation is the result of the movement of prices from a year
to another This is calculated by comparing the movement of the price of the basket
of commodities from a year to another or a period to another Inflation is computed
using this formula:
𝐶𝑃𝐼𝑛
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = ( ) − 1 𝑥 100%
𝐶𝑃𝐼0
Where:
CPIn = consumer price index - current year
CPI0 = consumer price index - base year
The consumer price index represents the price of the basket of commodities for a
particular period. In financial modelling, you need the inflation to be used as driver for
certain operating and capital expenditures. There are two ways to calculate the value: (1)
nominal and (2) real
Nominal financial models are already in current prices, meaning, the prices slated in the
model already assumes that the prices grew or decline, in the case of inflation or deflation
respectively. Some uses the headline inflation to determine the current price. Real
financial model, on the other hand, does not include the effect of changes in prices, but
rather preserve the price of operating expenses and capital expenditures, as if no
changes in prices occur. If the financial model is in real prices, the cost of capital should
also exclude the effect of inflation.
With the given equation, to illustrate, that in year 2019 the CPI is 151 meaning the cost
of the basket is Php151, In year 2020, the CPI published is Php155. Obviously, the price
of the basket grew, hence, inflation is expected to be 2.64% [(155/151)-1 x 100%). On
the other hand, if the CPI published for 2020 is Php149, then it will be a deflation or
decrease in prices at 1.32% [(149/151) -1x 100%).
To illustrate its application, supposed you are projecting for how much is the
communication costs for 2021 when the cost in 2020 is Php5 Million. Given the calculated
inflation of 2.64%, the communication costs to be incorporated in the financial model is
Php5.132 Million.
P a g e | 20
Other indicator is population growth rate. Population growth rate is factored in to serve as
a growth driver for the demand of the product, particularly for the merchandising or
manufacturing business. The services sector may use the growth rate in the businesses
or the industry or sector that they are going to serve. The formula to calculate for the
population growth rate is similar with the inflation, except that the input is the population
count of a particular segment in a particular year.
To illustrate, suppose that in Barangay A in 2019 the population is 25,200. The survey is
conducted in 2020 and the population is 26,460. Using the formula of inflation to calculate
for population growth rate:
26,460
𝑔= ( ) − 1 𝑥 100%
25,200
g = 5%
To illustrate the application, assuming that the estimated consumption of pandesal in

Barangay A is 5 pcs average per head. If you are going to project the number of pandesal
to be sold in 2021, it will be 138,915 units computed as follows:
Current pan de sal sold (26,460 x 5) 132,300
Increase in pan de sal (26,460 x 5% x 5) 6,615
Total Estimated pandesal 138,915
Financial ratios may be used as tools to determine the growth drivers and assumptions.
Trend analysis will also help you establish the trajectory of growth pattern. The financial
modeler must assess whether the company can sustain the pattern otherwise it is
conservative to assume a less aggressive growth. Normally the weighted growth pattern
will be considered in the long term financial perspective. It must be assessed whether the
average year on year growth will be sustained or may be surpassed.
To illustrate, PAP Company's historical production grows 10% per year. It expected that
in the next five years the probability are as follows:
Scenario Rate Probability

А 5% 10%
B 10% 40%
С 15% 50%
P a g e | 21
With the given information, the weighted average growth rate to be used is 12%
computed as follows:
Scenario Rate Probability Weighted
(1) (2) (1) x (2)
А 5% 10% 0.5%
B 10% 40% 4.0%
С 15% 50% 7.5%
Total 12.0%
this situation, the financial modeler can safely use the 12.0% for projecting sales moving
forward. Hence, if the sales for this year was reported to 8.500 units then under the
average sales computed will result to 9,520 units sold.
3. Determine the reasonable cost of capital

In determining the reasonable cost of capital, the financial modeler must be able to
use the appropriate parameters for the company. Generally, cost of debt and cost of
equity are weighted to determine the cost of capital reasonable for the valuation.
4. Apply the formulae to compute for the value Normally in Financial Modelling, DCF is
used to calculate for the value. Since most information are already available in
Financial model, it can be easier to use other capital budgeting techniques like
Internal Rate of Return, Profitability Index etc.
P a g e | 22
Illustrative Example 2.
Quantum and Time Inc. projected volume of smartphones to be sold in Year 1 is 138,915
units, assuming 5% growth every year, and the estimated required rate of return of 10%.
The smartphone is sold at Php 15 per unit with a cash net income margin of 20%. Q and
T equipment is capable of producing the volume required for 10 years. It was noted that
the company has outstanding debt of Php 500,000.00
Using the inputs, the financial model may be presented through:
P a g e | 23
Components of Financial Model
As described in the earlier part of this chapter, a financial model should be

understandable, printable and auditable. The financial model should be designed in
a way that the investor or the client of the analysts or the proponent themselves can
understand the dynamics and follow the drivers to enable them to have a better
appreciation and sound judgment of the results. Please bear in mind that the results
of the financial models are just guide for the investors or even sellers of investment
to determine the reasonable value.
As a quick guide in developing a financial model the following components are

recommended, particularly when using Microsoft Excel:
• Title Page
This provides an overview and the project being valued or assessed. This
includes also necessary information to secure the proprietary rights of the
modeler or the firm he or she is working with. It may also include data cut-off
to serve as a guide to the readers
• Data Key Results
This sheet summarizes the results of the study. This will serve as the
dashboard to enable the modelers to analyze the results and to facilitate the
readers' appreciation on the results of the project. This also facilitate
preparation of pertinent reports.
This also contains the valuation results, scenarios, and sensitivity analysis.
Graphs can also be found in this sheet.
• Assumption Sheet
This sheet summarizes the assumptions used in the model This is normally an
input sheet where all inputs should be made The information that can be found
in this sheet must be linked to all the output sheets like Pro-forma Financial
Statements, Supporting Schedules and Data Key Results
• Pro forma Financial Statements
This presents the 3 components of the financial statements namely Statement

of Income, Statement of Financial Position and Statement of Cash Flows In
this sheet, you can also find some key financial ratios particularly those that
has to do with financial performance and efficiency ratios.
P a g e | 24
Some modelers also find it convenient to have their valuation computation be

done in this sheet since the inputs of cash flows are already available here.
• Supporting Schedules
This is like a subsidiary ledger which provides supporting computation to the

components of the pro forma financial statements There is no limit for the
supporting schedules the only challenge is that the electronic financial models
consume large amount of data because of the supporting schedules
MODULE 5. VALUATION OF FIXED INCOME INSTRUMENTS
What are Fixed Income Securities?

Fixed income securities are a type of debt instrument that provides returns in the form
of regular, or fixed, interest payments and repayments of the principal when the security
reaches maturity. The instruments are issued by governments, corporations, and other entities
to finance their operations. They differ from equity, as they do not entail an ownership interest
in a company, but they confer a seniority of claim, as compared to equity interests, in cases of
bankruptcy or default.
The term fixed income refers to the interest payments that an investor receives,
which are based on the creditworthiness of the borrower and current interest rates. The
borrower is willing to pay more interest in return for being able to borrow the money for a
longer period of time.
Many examples of fixed income securities exist, such as bonds (both corporate and
government), Treasury Bills, money market instruments, and asset-backed securities, and they
operate as follows:
Bonds
Bonds are loans made by investors to an issuer, with the promise of repayment of the
principal amount at the established maturity date, as well as regular coupon payments
(generally occurring every six months), which represent the interest paid on the loan. Bonds
are typically issued by governments or corporations that are looking for ways to finance
projects or operations.
Treasury Bills
Considered the safest short-term debt instrument, Treasury bills are issued by the
government. With maturities ranging from one to 12 months, these securities most commonly
involve 28, 91, and 182-day (one month, three months, and six months) maturities. These
instruments offer no regular coupon, or interest, payments.
Treasury bills are sold at a discount to their face value, with the difference between their
market price and face value representing the interest rate they offer to investors. As a simple
example, if a Treasury bill with a face value, or par value, of 100 sells for 90, then it is offering
roughly 10% interest.
Money Market Instruments

Money market instruments include securities such as commercial paper, banker’s
acceptances, certificates of deposit (CD), and repurchase agreements (“repo”). Treasury bills
are technically included in this category, but due to the fact that they are traded in such high
volume, they have their own category.
Asset-Backed Securities (ABS)
Asset-backed Securities (ABS) are fixed income securities backed by financial assets that
have been “securitized,” such as credit card receivables, auto loans, or home-equity loans.
ABS represents a collection of such assets that have been packaged together in the form of a
single fixed-income security. For investors, asset-backed securities are usually an alternative
to investing in corporate debt.
Risks of Investing in Fixed Income Securities

Principal risks associated with fixed-income securities concern the borrower’s
vulnerability to defaulting on its debt. Such risks are incorporated in the interest or coupon
that the security offers, with securities with a higher risk of default offering higher interest
rates to investors.
Additional risks include exchange rate risk for securities denominated in a currency
other than the US dollar (such as foreign government bonds) and interest rate risk – the risk
that changes in interest rates may reduce the market value of a fixed-income security that an
investor holds.
For example, if an investor holds a 10-year bond that pays 3% interest, but then later
on interest rates rise and new 10-year bonds being issued offer 4% interest, then the bond
the investor holds that pays only 3% interest becomes less valuable.
BOND VALUATION
When a bond is first issued, it is generally sold at par, which is the face value of the
bond. Most corporate bonds, for instance, have a face and par value of 1,000. The par value
is the principal, which is received at the end of the bond's term, i.e., at maturity.
Sometimes when the demand is higher or lower than an issuer expected, the bonds
might sell higher or lower than par. In the secondary market, bond prices are almost always
different from par, because interest rates change continuously. When a bond trades for more
than par, then it is selling at a premium, which will pay a lower yield than its stated coupon
rate, and when it is selling for less, it is selling at a discount, paying a higher yield than its
coupon rate. When interest rates rise, bond prices decline, and vice versa. Bond prices will
also include accrued interest, which is the interest earned between coupon payment dates.
Clean bond prices are prices without accrued interest; dirty bond prices include accrued
interest.
Example: (source: https://thismatter.com/)

Given:
Par Value: 100
Nominal Yield: 5%
Annual Coupon Payment: $5
Maturity: 5 years
Market Interest Rate = 4%
Case 1: Two (2) Annual Coupon Payments
Since there are 10 semiannual payment periods, the market interest rate is divided by 2
to account for the shorter period:
5 1 100
Bond
= [1 – ]+ = 104.49
Price
.04 (1.02) (1.02)
Case 2: One (1) Annual Coupon Payment, resulting in 5 payment periods at the market interest
rate:
5 1 100
Bond
= [1 – ]+ = 104.45
Price
.04 (1.04)5 (1.04)5
Bond Value Equals the Sum of the Present Value of Future Payments
A bond pays interest either periodically or, in the case of zero-coupon bonds, at maturity.
Therefore, the value of the bond is equal to the sum of the present value of all future payment,
hence, it is the present value of an annuity, which is a series of periodic payments. The present
value is calculated using the prevailing market interest rate for the term and risk profile of the
bond, which may be more or less than the coupon rate. For a coupon bond that pays interest
periodically, its value can be calculated as:
Bond Value = Present Value (PV) of Interest Payments + Present Value of Principal Payment
Bond Value = PV(1st Payment) + PV(2nd Payment) + ... + PV(Last Payment) +

PV(Principal Payment)
Bond Price Formula
P
Clean Bond Price = + + ... + +
(1+r/k)1 (1+r/k)2 (1+r/k)kn (1+r/k)kn
C = coupon, or interest, payment per period k =

number of coupon periods in 1 year
n = number of years until maturity r

= annualized market interest rate P =
par value of bond
Example: Calculating Bond Value as the Present Value of its Payments
Suppose a company issues a 3-year bond with a par value of $1,000 that pays 4%
interest annually, which is also the prevailing market interest rate. What is the present value of
the payments?
The following table shows the amount received each year and the present value of that amount.
As you can see, the sum of the present value of each payment equals the par value of the
bond.
Year Payment Amount Received Present Value
1 Interest $40 $38.46
2 Interest $40 $36.98
3 Interest + Principal $1040 $924.56
Totals $1120 $1,000.00
The above formula can be simplified by using the formula for the present value of an annuity,
and letting k=2 for bonds that pay a semiannual coupon:
Simplified Bond Price Formula for Semiannual Coupon Bonds
C 1 P
Clean Bond Price = [ 1 – ]+
r (1+r/2)2n (1+r/2)2n
C = Annual payment from coupons n = number of

years until maturity r = market annual interest rate
P = par value of bond
Note that the above formula is sometimes written with both C and r divided by 2; the results
are the same, since it is a ratio.
For more examples with explanation click this link!
https://youtu.be/1RmImYghQLc
MARKET VALUE APPROACH
Market Value Approach follows the concept that the value of the business can be
determined by reference to reasonably comparable guideline companies for which
transaction values are known. The values may be known because these companies are
publicly traded or because they were recently sold, and the terms of the transaction were
disclosed. The business valuation methods under the market approach that are typically
used in professional business appraisals include comparative transaction
method/comparative private company sale data method, guideline publicly traded
company method and use of expert opinions of professional practitioners.
Market-based business valuation methods are routinely used by business owners,

buyers and their professional advisors to determine the business worth. This is especially
so when a business sale transaction is planned. After all, if you plan to buy or sell your
business, it is a good idea to check what the market thinks about the selling price of similar
businesses.
The market approach offers the view of business market value that is both easy to grasp
and straightforward to apply. The idea is to compare your business to similar businesses
that have actually sold.
If the comparison is relevant, analysts can gain valuable insights about the kind of price
the business would fetch in the marketplace. Analysts can use the market-based business
valuation methods to get a quick sanity check of the pricing estimate or use this as a
compelling market evidence of the likely business selling price.
Empirical / Statistical Approach
Empirical or Statistical approach generally uses research and database processing in

order to come up with conclusion and recommendation. The approach requires
references and evidences to support the determination and evaluation. Trend analysis
and benchmarking maybe used to process the information.
Comparative Private Company Sales Data
This is an empirical approach. This is formerly known as comparative transaction as

guideline method or comparative business sales data.
This method involves finding out prior transactions mergers and acquisitions, divestiture,
etc.) of comparable companies. Transaction’s data can be obtained by finding out the
exact industry of the business under consideration using the established industry
classification methods and searching valuation databases for historical valuation
evidence. A number of publications collect and disseminate information on transactions.
Most publications make their databases accessible on the Internet for free on a per-use
basis or annual subscription access. Among the most widely used are:
• Institute of Business Appraisers (IBA)
• BIZCOMPS
• Pratt's Stats
• Done Deal
• Mid Market Comps (ValueSource)
• Mergerstat®
In selecting which method to employ in a valuation assignment, the definition of value,

the size of the company being valued and the magnitude of the valuation stake (majority
vs minority) are important. A majority stake in a large well-established should be valued
relative to either (a) a prior transaction of the same company involving a majority stake or
(b) guideline transactions representing a majority stake involving a comparable company.
A minority stake should be valued using the guideline public company method after
applying proper discounts and adjustments.
The advantage of this approach is that source data is reliable and comparable data
includes sales of small businesses that can be similar the small business being valued.
Although the limitation of this approach is that there is insufficient market evidence in
some industries, and it will require careful data selection, analysis and consistent data
reporting standards.
Guideline Public Company Data
The guideline public company method involves identifying a comparable company and
obtaining the stock price for the company's listed securities. Publicly listed companies
(PLCs) are required to file their financial statement electronically with the Securities and
Exchange Commission (SEC). These filing are public information and are available on
the SEC website at https://www.sec.gov.ph Information are also available in Philippine
Stock Exchange website at https://pse.com.ph
In most cases, the stock prices as obtained from a public market represent a minority
stake. The advantage of this method lies in the availability of a large set of recent data.
However, it might not be very appropriate in valuing early-stage and/or small businesses.
In using public company data to value private companies, proper adjustments must be
made to the benchmarks being used on account of size, growth potential, capital
structure, business life cycle (i.e. early stage or maturity), etc.
The advantage of this approach is that there are plenty of transaction data available from
the public capital markets. Business sale data reporting is generally consistent and
reliable and business financial reporting data are readily available. Although it can be
noted that the limitation of this approach is that comparison to small businesses may not
be as relevant, the data generally involves sales of non-controlling business ownership
interest (not the entire company) and data requires adjustment for lack of marketability of
private company ownership interest.
Prior Transactions Method
The prior transaction method involves looking up historical transactions in securities of

the business undervaluation. The valuation might be for minority stake such a historical
stock quote from a listed stock exchange or it might be for a majority stake such a merger
and acquisition transaction involving the business. Additional considerations in selecting
prior transactions as a benchmark include the timeline of the transaction, the economic
situation at the time of the transaction, etc.
The advantage of this approach is that it is already a good reference for valuation, if the
data is available, Since this is reliant heavily on the data, absence of a good data may
not enable this approach to produce reliable results.
Comparable Company Analysis
In Financial Management, financial ratios are used as tools to assess and analyze
business results. Recall that one of these purposes can be used to determine the value.
These financial ratios are P/E Ratio, Book to Market Ratio, Dividend Yield Per Share and
EBITDA Multiple. Ratios or multiples are useful tools for doing comparative company
analysis. The advantage of having ratios and multiples is that it creates better and relevant
comparison knowing that opportunities or investments have distinct drivers of their
performance.
Comparable company analysis is a technique that uses relevant drivers for growth and
performance that can be used as proxy to set a reasonable estimate for the value of an
asset or investment prospective.
In determining the value using comparable company analysis, the following factors must
be considered:
• Comparators must be at least with the similar operations or in the similar industry
• Total or absolute values should not be compared
• Variables used in determining the ratios must be the same
• Period of observation must be comparable
• Non quantitative factors must also be considered
Price - Earnings Ratio
Price - earnings ratio (P/E) Ratio represents the relationship of the market value per share
and the earnings per share. It sends the signal on how much the market perceives the
value of the company as compared to what it actually earns. P/E Ratio is computed using
the formula:
P/E Ratio = Market Value Per Share / Earnings Per Share

To illustrate, Chandelier Co. is a listed company with the market value per share of
Php12.0 and reported earnings per share of Php 4.0.
Using the equation, the P/E ratio is 3. This means that the Chandelier Company can
create 3x the value of what it earns.
PIE Ratio is also known as P/E Multiples or Price Multiples. To determine the value of a
company using P/E ratio, management accountants and analysts use P/E of the
comparable company.
For instance, Jopet Hotels and Leisure is a hospitality company. Based on the income
statement of the company, it reported earnings of Php7.00 per share. Based on the listed
companies under hospitality industry, the average P/E ratio is 4.25. With the foregoing
information, you can expect that the value of Jopet Hotels and Leisure is Php29.75 per
share [Php29.75 = Php7.00 x 4.25)
Book-to-Market Ratio
Book-to-Market ratio is used to determine the appreciation of the market to the value of
the company as compared to the value it reported under its Statement of Financial
Position. It may be recalled that the book values of the company are based on historical
costs and does not purely incorporate the value in the market now. However, the only
limitation of this ratio is that certain values incorporated do not represent the true value of
the company. Hence, further due diligence is imperative.
Book-to-Market ratio is computed using this equation:
Book to Market Ratio = Net Book Value Per Share / Market Value Per Share
Book Value per share can be derived by dividing the net book value to the number of
outstanding shares available to common or ordinary Net book value is the difference of
the total assets and the total liabilities. This represents the claim of the equity stockholders
to the company.
To illustrate, Chandelier Co. reported a Book Value per share of Php35 and with a market
value per share of Php12.50. The Book-to Market ratio is 2.80 which is computed as
follows: Book to Market Ratio = 35.0 / 12.50 . Book to Market Ratio = 2.80. This means
that for every Php35 per share that is owned by a stockholder it is 2.8x larger than its
value in the market.
Dividend-Yield Ratio
Dividend Yield Ratio describes the relationship between the dividends received per share
and the appreciation of the market on the price of the company. Dividend-Yield Ratio is
also known as dividend multiple. Next to Price Earnings Multiple, this is also a popular
tool because it provides the investors with the value which they can actually get from the
company.
The Dividend Yield Ratio (DYR) is computed using this equation
Dividend Yield Ratio = Dividend Per Share / Market Value Per Share
To illustrate, Chandelier Co. declared and paid dividends of Php1.50 per share and their
market value per share is Php12.50. Based on the foregoing, the dividend yield ratio is
0.12 .
This means that for every Php1.50 dividends they pay it will translate into 12% of the
market value of the equity. Using this as a tool for comparable company analysis, DYR
will works as a multiplier to the dividends per share declared by the company.
EBITDA Multiple
EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization represents

for the net amount of revenue after deducting operating expenses and before deducting
financial fixed costs, taxes and non-cash expenses. Given the components, EBITDA can
serve as a proxy of cash flows from operating activities before tax. Traditionally, cash
flows from operating activities is computed by collections less payments for operating
expenses. Indirectly, EBITDA can be computed from net income plus depreciation and
amortization and incorporating working capital adjustments.
EBITDA Multiple is determined by this equation
EBITDA Multiple = Market Value per Share / EBITDA per share
EBITDA per share is derived by dividing EBITDA by outstanding share for common equity
or ordinary shares.
To illustrate, Chandelier Co. reported EBITDA per share of Php6 and the market value
per share being Php12.0. Given the equation the EBITDA Multiple is 2 [2 = Php12.0 -
Php6.0]
This means that the value of the firm to the market is 2x for every peso of EBITDA earned.
In summary, comparable company analysis uses tools to enable the comparison between
companies given the differences in 3s - Strategy, Structure and Size. The objective is to
enable the analyst or management accountant to determine the value of the company
based on the behavior of similar businesses in the industry that more or less captured the
risks factors and other micro and macro-economic considerations.
Heuristic pricing rules method
Another method may consult and use the expert opinion of professional practitioners
which uses Heuristic pricing rules method. In this method, analysts use business pricing
formulas that are developed based on the expert opinion of professionals involved in
business sales. The best-known professional group that does this is the business
intermediaries that broker business sale transactions in specific industries. Their
knowledge of the marketplace and direct exposure to transactions puts these experts in
an excellent position to estimate the likely business selling price. The advantage of this
approach is that pricing multiples based on the expert opinion of active market
participants is made available. Also, pricing formulas are often relied upon both by
practitioners and their client business owners and buyers when pricing a deal. However,
since these are based on expert's opinion, pricing multiples may not be sufficiently backed
by rigorous statistical analysis. There will also be a concern on availability of information
for non-brokered business deals.
MODULE 6. RELEVANT VALUATION CONCEPTS
Mergers and Acquisitions – M&A
Mergers and acquisitions (M&A) are a general term used to describe the consolidation of
companies or assets through various types of financial transactions, including mergers,
acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.
The Essence of Merger
The terms "mergers" and "acquisitions" are often used interchangeably, although in actuality, they
hold slightly different meanings. When one company takes over another entity, and establishes
itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target
company ceases to exist, the buyer absorbs the business, and the buyer's stock continues to be
traded, while the target company’s stock ceases to trade.
On the other hand, a merger describes two firms of approximately the same size, who join forces
to move forward as a single new entity, rather than remain separately owned and operated. This
action is known as a "merger of equals." Both companies' stocks are surrendered and new
company stock is issued in its place. Example: both Daimler-Benz and Chrysler ceased to exist
when the two firms merged, and a new company, Daimler Chrysler, was created. A purchase deal
will also be called a merger when both CEOs agree that joining together is in the best interest of
both of their companies.
Unfriendly ("hostile takeover") deals, where target companies do not wish to be purchased, are
always regarded as acquisitions. A deal is can thus be classified as a merger or an acquisition,
based on whether the acquisition is friendly or hostile and how it is announced. In other words,
the difference lies in how the deal is communicated to the target company's board of directors,
employees and shareholders.
Mergers
In a merger, the boards of directors for two companies approve the combination and seek
shareholders' approval. Post-merger, the acquired company ceases to exist and becomes part of
the acquiring company. For example, in 1998 a merger deal occurred between Digital Computers
and Compaq, whereby Compaq absorbed Digital Computers. Compaq later merged with Hewlett-
Packard in 2002. Compaq's pre-merger ticker symbol was CPQ. This was combined with Hewlett-
Packard's ticker symbol (HWP) to create the current ticker symbol (HPQ).
Acquisitions
In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm,
which does not change its name or alter its legal structure, and often preserve the existing stock
symbol. An example of this transaction is Manulife Financial Corporation's 2004 acquisition of
John Hancock Financial Services, where both companies preserved their names and
organizational structures. Acquisitions may be done by exchanging one company's stock for the
others or using cash to purchase the target company's shares.
Consolidations
Consolidation creates a new company through combining core businesses and abandoning the
old corporate structures. Stockholders of both companies must approve the consolidation, and
subsequent to the approval, receive common equity shares in the new firm. For example, in 1998,
Citicorp and Traveler's Insurance Group announced a consolidation, which resulted in Citigroup.
Tender Offers
In a tender offer, one company offers to purchase the outstanding stock of the other firm, at a
specific price rather than market price. The acquiring company communicates the offer directly to
the other company's shareholders, bypassing the management and board of directors. For
example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals
for $438 million. While the acquiring company may continue to exist — especially if there are
certain dissenting shareholders — most tender offers result in mergers.
Acquisition of Assets
In an acquisition of assets, one company directly acquires the assets of another company.
The company whose assets are being acquired must obtain approval from its shareholders. The
purchase of assets is typical during bankruptcy proceedings, where other companies bid for
various assets of the bankrupt company, which is liquidated upon the final transfer of assets to
the acquiring firms.
Management Acquisitions
In a management acquisition, also known as a management-led buyout (MBO), a company's

executives purchase a controlling stake in another company, taking it private. These former
executives often partner with a financier or former corporate officers, in an effort to help fund a
transaction. Such M&A transactions are typically financed disproportionately with debt, and the
majority of shareholders must approve it. For example, in 2013, Dell Corporation announced that
it was acquired by its chief executive manager, Michael Dell.
The Structure of Mergers
Mergers may be structured in multiple different ways, based on the relationship between the two
companies involved in the deal.
Horizontal merger: Two companies that are in direct competition and share the same product lines
and markets.
Vertical merger: A customer and company or a supplier and company. Think of a cone supplier
merging with an ice cream maker.
Congeneric mergers: Two businesses that serve the same consumer base in different
ways, such as a TV manufacturer and a cable company.
Market-extension merger: Two companies that sell the same products in different market
Product-extension merger: Two companies selling different but related products in the same
market.
Conglomeration: Two companies that have no common business areas.
Mergers may also be distinguished by following two financing methods--each with its own
ramifications for investors.
Purchase Mergers: As the name suggests, this kind of merger occurs when one company
purchases another company. The purchase is made with cash or through the issue of some kind
of debt instrument. The sale is taxable, which attracts the acquiring companies, who enjoy the tax
benefits. Acquired assets can be written-up to the actual purchase price, and the difference
between the book value and the purchase price of the assets can depreciate annually, reducing
taxes payable by the acquiring company.
Consolidation Mergers: With this merger, a brand-new company is formed, and both
companies are bought and combined under the new entity. The tax terms are the same as those
of a purchase merger.
Valuation in M & A
Both companies involved on either side of an M&A deal will value the target company differently.
The seller will obviously value the company at the highest price as possible, while the buyer will
attempt to buy it for the lowest possible price. Fortunately, a company can be objectively valued
by studying comparable companies in an industry, and by relying on the following metrics:
Comparative Ratios: The following are two examples of the many comparative metrics on which
acquiring companies may base their offers:
Price-Earnings Ratio (P/E Ratio): With the use of this ratio, an acquiring company makes an offer
that is a multiple of the earnings of the target company. Examining the P/E for all the stocks within
the same industry group will give the acquiring company good guidance for what the target's P/E
multiple should be.
Enterprise-Value-to-Sales Ratio (EV/Sales): With this ratio, the acquiring company makes an offer
as a multiple of the revenues, again, while being aware of the price-to- sales ratio of other
companies in the industry.
Replacement Cost: In a few cases, acquisitions are based on the cost of replacing the target
company. For simplicity's sake, suppose the value of a company is simply the sum of all its
equipment and staffing costs. The acquiring company can literally order the target to sell at that
price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble
good management, acquire property and purchase the right equipment. This method of
establishing a price certainly wouldn't make much sense in a service industry where the key assets
– people and ideas – are hard to value and develop.
Discounted Cash Flow (DCF): A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value, according to its estimated future cash flows. Forecasted
free cash flows (net income + depreciation/amortization - capital expenditures - change in working
capital) are discounted to a present value using the company's weighted average costs of capital
(WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
What is a Divestiture?
A divestiture (or divestment) is the disposal of company’s assets or a business unit through a
sale, exchange, closure, or bankruptcy. A partial or full disposal can happen, depending on the
reason why management opted to sell or liquidate its business’ resources. Examples of
divestitures include selling intellectual property rights, corporate acquisitions and mergers, and
court-ordered divestments.
What are the reasons behind a divestiture?
There are many reasons why a corporation may decide they need to sell an asset, a business
unit, or the entire company. Some of the most common reasons include:
To sell off redundant business units

Most companies decide to sell off a part of their core operations, if they are not performing, in
order to place more focus on the units that are performing well and are profitable.
To generate funds
Selling a business unit for cash is a source of income without a binding financial obligation.
To increase resale value

The sum of a company’s individual asset liquidation value exceeds that of the market value of its
combined assets, meaning there is more gain realized in liquidation than there is in retaining
existing assets.
To ensure business survival or stability

Sometimes, companies face financial difficulties; therefore, instead of closing down or declaring
bankruptcy, selling a business unit will provide a solution.
To comply with regulators

A court order requires the sale of a business to improve market competition.
Divestiture transactions are often lumped in with the mergers and acquisitions process. Most
people think of the buy-side of these transactions (buying businesses) but corporations also
actively look to sell non-performing or non-core assets to optimize their business.
Constantly reviewing a company’s portfolio of assets and optimizing it for the best performance
is an important part of corporate strategy.
Major Causes of Business Failure
The primary cause of business failure is mismanagement which accounts for more than 50% of
all causes.
Overexpansion, poor financial actions, an ineffective sales force, ad high production costs cause
business failure.
Poor financial actions including bad capital decisions (based on unrealistic sales
forecasts, failure to identify all relevant cash flows, or failure to assess risk properly), poor financial
evaluation of the company’s strategic plans prior to making financial commitments, inadequate or
nonexistent cash flow planning and failure to control receivables and inventories.
Economic activity downturns can contribute to the failure of the business. If the economy
goes into a recession, sales may decrease abruptly, leaving the company with high fixed costs
and insufficient revenues to cover them. Rapid rises in interest rates just prior to recession can
further contribute to cash flow problems and make it more difficult for the company to obtain and
maintain needed financing.
The final cause of business failure is corporate maturity. Business enterprise, like individuals, do
not have infinite lives. Like a product, a business enterprise goes through the stages of birth,
growth, maturity and eventual decline. The company’s management should attempt to prolong
the growth stage through research, new products and mergers.
Due Diligence
In the initial chapters, valuation techniques facilitate the process of determining the value of an
asset or an investment. In practice, especially those who will be doing their initial private offering
provide for investment prospectus that serves for the reference of the investor on how the fund
will be distributed or used from this the investor will have more or less an idea on what the risk he
or she is about to face.
In order to minimize the investment risk, due diligence is undertaken after the intent to purchase
or invest in a company. Due diligence is a process of validating the representations made by a
seller, normally to an investor. This process would require thorough examination of all records
that would be relevant in the realization of returns or the so-called advertised benefits. Some
investors would procure the services of an audit or forensic accountants to determine and validate
the inputs used in the determination of the value or whether there would be some information that
may pose the risk in the realization of the perceive returns. The due diligence team is composed
of lawyers, auditors and technical experts. Other than the inspection and audit of records, actual
field or site inspection is also taken.
Due diligence was started to be a formal exercise since the mid 1900. In the United States of
America, the Securities Act of 1933 requires full disclosure of information from the dealers and
brokers, this provides protection to the investors in engaging with any concealed information that
would impair the value of the investment. Penalties and sanctions were imposed by the law. This
is to protect the investors at the same time the economy that due to information or potential risks
that were not disclosed may result economic sabotage
In the Philippines, Republic Act 8799 or the Securities Regulation Code which serves as the
equivalent regulation that protect investors in the country. This law is actually the charter of the
Securities and Exchange Commission or the SEC. The law enumerates the information that
needs to be disclosed by companies and the frequency to enable the commission to monitor the
operations of the partnerships and corporations in the Philippines. Certain penalties were imposed
by the law for noncompliance with the requirements set.
Types of Due Diligence
Due diligence varies and designed according to the size and nature of the investment. The
exercise maybe categorized into who conducts the process and what is the nature of the
prospective investment,
Due Diligences According to the Executor
• Corporate Due Diligence
If the due diligence exercise is to be conducted or commissioned by a company or

corporation that will invest to business this is considered as Corporate Due Diligence. The
corporate due diligence normally commissioned external experts such as technical
experts, lawyers and auditors, since companies do not consider this exercise as their core
function. The cost of due diligence is considered as part of the cost of investment of the
company, given that the investments entered by corporations are significant it is fitting to
incur costs rather than impairing the value of the investment in the middle of the
operations.
• Private Due Diligence
If the due diligence exercise is facilitated or conducted by individual or at least few

individual investors but is not yet incorporated this is called private due diligence. While
the broker-dealers are legally mandated to conduct due diligence on a security before they
bring the investment into the market, individual investors still would require due diligence
for the value that they initially calculated. Normally. private due diligence was done by the
investors themselves since most of them are not capable of forming or hiring a team. In
most cases, private investors are less aggressive than the corporations. Although due
diligence team can still be constituted, but for as long as the engagement is with a private
individual is considered private due diligence.
• Government Due Diligence
In some cases, government needs to do due diligence either for investment or regulatory
purposes. If the due diligence is commissioned or conducted by the government, it is
called as government due diligence. Most of the time, this type of due diligence is for the
protection of the public or evaluation of the operations of the company for the public
interest.
Due diligence According to Subject
• Hard Due Diligence
When the due diligence focuses on the data and hard evidential information this is called
hard due diligence. Hard due diligence is where the lawyers or legal team, accountants,
and deal facilitators are actively engaged. Normally, hard due diligence focuses on
earnings before interest, taxes, depreciation and amortization (EBITDA), the aging of
receivables, and payables, cash flow, and capital expenditures. Intellectual property and
physical capital are also focus, particularly for subject companies belong to sectors such
as technology or manufacturing
Driven by mathematics and legalities, hard due diligence is prone to unrealistic and
biased interpretations by eager sales people. Soft due diligence acts as a counterbalance
when the numbers are being manipulated or overemphasized.
Examples of hard due diligence activities include, but not limited to:
o Review and audit of the financial statements
o Validation of the projections for future performance
o Analysis of the market or industry where the subject company belongs
o Review of operational policies, process and procedures
o Review of potential or ongoing litigation Review of antitrust considerations
o Assessment of subcontractor and other third-party relationships
• Soft Due Diligence
Soft due diligence focuses on the internal affairs or the internal organization of the
company and its customers. So essentially, this type of due diligence is designed to
validate the qualitative factors that affect the realization of returns, which measurement
cannot be normally done by use of mathematical calculation and therefore harder to
conduct compared to hard due diligence which concentrates to verifiable data.
Most of the time the Hard Due Diligence is conducted and focused heavily on the
quantitative and economic drivers of the returns. But recently, soft due diligence started
to be seen with great importance since the realization of the perceive returns which drives
the value of an investment will be delivered by the employees and the customers or clients.
Examples of soft due diligence activities include, but not limited to:
o Organizational Review including Succession Plans

o Competency Assessment
o Quality Assurance on Customer Services
o Quality Assurance on Processes
o On the ground interview and examination
• Combined Due Diligence
When the focus of the due diligence exercise is to cover both quantitative and qualitative
areas of the company or business it is considered as the combined due diligence.
It is also known as comprehensive due diligence In the combined due diligence is where
the hard and soft due diligence activities intertwine, especially when the focus of the
evaluation will come across the quantitative impact of those covered by the soft due
diligence.
For example, compensation and benefits, retirement packages, quantitative impact of

collective bargaining agreement, cost benefit analysis of customer service initiatives etc.
These programs are not only based on real numbers, making them easy to incorporate
into post-acquisition planning but they can also be discussed with employees and used to
gauge cultural impact.
Factors to be considered in the Due Diligence Process
Based on the foregoing discussions, the due diligence process varies from an investment
prospect to another. There are various strategies on how the due diligence process was
administered. The process would also be affected by the factors or the elements that
would affect the investors decision to proceed with the investment or not.
o Market Capitalization The company's market capitalization or total value provides

an indication on how volatile the value of the company in the market. Recall that
the market capitalization when divided into the number of outstanding shares is
the market value per share. This represents on how broad its ownership is and the
potential size of the company's target markets.
The market capitalization is also used to categorize the companies in terms of its
volatility. The Philippine Stock Exchanges observe 3 categories of market
capitalization i.e. Large-cap, Mid-cap and Small cap. Large-cap companies tend
to have stable revenue streams and a large, diverse investor base, which tends to
lead to less volatility. Mid-cap and small-cap companies typically have greater
fluctuations in their stock prices and earnings than large corporations. In some
countries, they also have Mega-cap which has larger values than large-cap.
o Performance/Profitability Trend Analysis
The historical performance and trend of the company would add more integrity on
the realization of the future earnings. The results of the performance and
profitability trend analysis may provide sufficient data for the projection. Some
analysts use regression line analysis to some project the future cash flows based
on the historical trend. Some of the focus of the performance are revenue growth,
net income growth, net income margin, EBITDA margin, return on invested capital,
return on total assets etc.
o External Environment Analysis
Assessing the position of the company in the industry is also a good input to the
due diligence exercise. It is believed that industry benchmarking would allow the
analyst to decipher how the target investment fair with the other players in the
industry. This may address the question - Are the variables inputted in the
valuation relatively the same with the other industry players?
By looking into the comparable companies will enable the validation process, this
is because if the companies used as index in the market can perform the same
level assumed in the valuation then it is highly probable. This also involves
scanning the market forces that may have an impact to the business. A sound test
is to validate that factors impact to the company for 5 to 7 years.
o Management and Share Ownership
Assessment of the personalities involved in the governance and policy making of

the company is also critical. Their leadership style may serve as a reference for
the analyst or investor to assess the integrity of the initial valuation. Newer
companies tend to be founder-led. It may be helpful to conduct research on the
background of the members of the management team to find out their level of
expertise and experience. This is why most companies, especially publicly listed
companies, has to post the profile of the members of the board in their annual
reports, company website and other official channels of the company.
Also, it would be helpful to understand the percentage of share of each member

of the board and whether they have been selling shares recently. High ownership
by top managers is a plus and low ownership is a red flag. Shareholders tend to
be best served when those running the company have a vested interest in the
performance of the stock.
o Financial Statements
The financial statements serve as the best document to support the financial
performance and financial position of the company including their cash flows.
Careful scrutiny of the contents of the financial statements particularly the notes to
the financial statements because it provides information on how the company is
seeing its future.
o Stock Price History
Similarly, investors should do the same to analyze stock price history. Investors
should research both the short-term and long-term price movement of the stock
and whether the stock has been volatile or steady. Compare the profits generated
historically and determine how it correlates with the price movement. Keep in mind
that past performance does not guarantee future price movements. If you're a
retiree looking for dividends, for example, you might not want a volatile stock price.
Stocks that are continuously volatile tend to have short term shareholders, which
can add extra risk factors for certain investors.
o Stock Dilution Possibilities
Related to the analysis of stock price history, investors should know how many
shares outstanding the company has and how that number relates to the
competition. If the company is planning on issuing more shares, the stock price
might take a hit and hence the possibilities of stock dilution.
o Market Expectations
Investors should find out what the consensus of market analysts is for earnings
growth, revenue, and profit estimates for the next two to three years. Information
may be available free in finance websites or from investment banks or other
financial institutions providing those services. Investors should also look for
discussions of long-term trends affecting the industry and company-specific news
about partnerships, joint ventures, intellectual property, and new products or
services.
o Long and Short-term Risks
The main objective of due diligence is essentially risk management. Hence, an

important part of the process is taking into consideration the long and short-term
risks. Make sure to understand both the industry-wide risks and company-specific
risks. Example of risks are outstanding legal or regulatory matters, unstable
management, movement of interest rates, product quality, market perception,
among others. Investors should keep a healthy attitude of professional skepticism
at all times, picturing worst-case scenarios and their potential outcomes on the
stock.

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*Not Intended for Publication. For Classroom Purposes Only*

Module 1 –Overview of Valuation Concepts and Methods

*Not Intended for Publication. For Classroom Purposes Only*

Just a quick recap ….

The Conceptual Framework of Accounting specifically mentions the underlying assumption of

The basic concepts or principles of accounting are:

Going Concern Assumption

Accrual Basis of Accounting

Accounting Entity Concept

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Monetary Unit Assumption

Valuation is the analytical (quantitative) process of determining the current or projected

• Frameworks for valuation

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in detail in the topic, step by step process o f valuation.

Valuation is based on economic factors, industry variables, and on the analysis of

1. Going concern value

Details of the above concepts will be discussed in the respective topics.

1. Why are you valuing?

Business valuation is an important exercise since it can help in improving the

*Not Intended for Publication. For Classroom Purposes Only*

Various reasons for performing a business valuation

• Exit strategy planning

Bankers, financing companies or any potential investors require an objective valuation

*Not Intended for Publication. For Classroom Purposes Only*

• Selling a share in a business

Business valuation is a critical financial analysis that needs to be done by a valuation

• Fundamental principles of valuation or value creation

Key Principles of Business Valuation

• The value of a business is defined only at a specific point in time.

A company’s valuation is essentially a function of its future cash flows except in in

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• The value of a business may be impacted by underlying net tangible assets

Business valuation measures of the relationship between t h e operational value of a

• Value is influenced by transferability of future cash flows

• Value is impacted by liquidity

*Not Intended for Publication. For Classroom Purposes Only*

Unit 2 – Asset Valuation Methods

What is Asset Valuation?

What is Equity Valuation?

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• Validated Operational and Financial Information

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Comparable company analysis, also called trading multiples or public market

• Total and absolute values should not be compared

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Example of Comparable Table

Economic Value Added

The elements that must be considered in using EVA are:

• Reasonableness of earnings or returns

Other factors to be considered in Valuation

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Example of Transaction Analysis

Leveraged Buyout (LBO)

A leveraged buyout model, or an LBO, is a type of company acquisition where total

*Not Intended for Publication. For Classroom Purposes Only*

Absolute and Relative Valuation

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Absolute Valuation Techniques

Discounted Residual Income

Discounted Free Cash Flow

Relative Valuation Techniques

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