Unit 3

Valuation of firm with different

valuation techniques

KUSOM
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 Course Contents

 Unit 2: Valuation of firm with different

valuation techniques 4.5 hrs
– NPV and Adjusted Present Value Approach
– WACC approach
– Flow to Equity Approach (ETF)
– Capital Cash Flow approach (CCF)
– A comparison of NPV, APV, FTE,CCF and WACC
– Valuation practice in Nepal

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 Misconceptions about Valuation

 Myth 1: A valuation is an objective search for “true” value

– Truth 1.1: All valuations are biased. The only questions are “how
much” and in which direction.
– Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise estimate of value
– Truth 2.1: There are no precise valuations.
– Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
 Myth 3: . The more quantitative a model, the better the valuation
– Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
– Truth 3.2: Simpler valuation models do much better than complex
3 ones.
 Approaches to Valuation

 1. Intrinsic valuation, relates the value of an asset to its intrinsic

characteristics: its capacity to generate cash flows and the risk in
the cash flows. In it’s most common form, intrinsic value is
computed with a discounted cash flow valuation, with the value of an
asset being the present value of expected future cash flows on that
asset.
 2. Relative valuation or Pricing, estimates the value of an asset by
looking at the pricing of 'comparable' assets relative to a common
variable like earnings, cashflows, book value or sales.
 3. Contingent claim valuation, uses option pricing models to
measure the value of assets that share option characteristics.

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 Basis for all valuation approaches

 The use of valuation models in investment decisions

(i.e., in decisions on which assets are under valued
and which are over valued) are based upon
– a perception that markets are inefficient and make mistakes
in assessing value
– an assumption about how and when these inefficiencies will
get corrected
 In an efficient market, the market price is the best
estimate of value. The purpose of any valuation
model is then the justification of this value.

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 Valuation of Levered Firm

 three approaches to valuation for the levered firm

 The analysis of these approaches is relevant for entire
firms as well as projects.
 Understand the effects of leverage on the value created
by a project
 Be able to apply Adjusted Present Value (APV), the
Flows to Equity (FTE) approach, and the WACC method
for valuing projects with leverage

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 Adjusted Present Value Approach

 The adjusted present value (APV) method

is best described by the following formula:
APV = NPV + NPVF
 (APV) is equal to the value of the project to
an unlevered firm (NPV) plus the net present
value of the financing side effects (NPVF).

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 Net present value of the financing
side effects (NPVF).

 There are four side effects of financing:

– The Tax Subsidy to Debt
– The Costs of Issuing New Securities
– The Costs of Financial Distress
– Subsidies to Debt Financing

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APV Example
Consider a project of the Pearson Company. The timing and size
of the incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is R0 = 10%:

$125 $250 $375 $500

𝑁𝑃𝑉10% = −$1,000 + + + +
(1.10) (1.10)2 (1.10)3 (1.10)4
𝑁𝑃𝑉10% = −$56.50

The project would be rejected by an all-equity firm: NPV < 0.

APV Example

 Now, imagine that the firm finances the project with $600 of debt
at RB = 8%.
 Pearson’s tax rate is 40%, so they have an interest tax shield
worth TCBRB = .40×$600×.08 = $19.20 each year.

 The net present value of the project under leverage is:

APV = NPV + NPV debt tax shield
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$19.20
𝐴𝑃𝑉 = −$56.50 + ෍
(1.08)𝑡
𝑡=1

𝐴𝑃𝑉 = −$56.50 + 63.59 = $7.09

 So, Pearson should accept the project with debt.
Flow to Equity Approach

 Discount the cash flow from the project to the

equity holders of the levered firm at the cost
of levered equity capital, RS.
 There are three steps in the FTE Approach:
– Step One: Calculate the levered cash flows
(LCFs)
– Step Two: Calculate RS.
– Step Three: Value the levered cash flows at RS.
Step One: Levered Cash Flows

 Since the firm is using $600 of debt, the equity

holders only have to provide $400 of the initial
$1,000 investment.
 Thus, CF0 = –$400
 Each period, the equity holders must pay
interest expense. The after-tax cost of the
interest is:
B×RB×(1 – TC) = $600×.08×(1 – .40) = $28.80
 Step One: Levered Cash Flows

CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600

CF2 = $250 – 28.80
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4
Step Two: Calculate RS
𝐵
𝑅𝑆 = 𝑅0 + (1 − 𝑇𝐶 )(𝑅0 − 𝑅𝐵 )
𝑆
B B
To calculate the debt to equity ratio, , start with
4 S V
$125 $250 $375 $500 19.20
𝑃𝑉 = + + + + ෍
(1.10) (1.10)2 (1.10)3 (1.10)4 (1.08)𝑡
𝑡=1

P V = $943.50 + $63.59 = $1,007.09

B = $600 when V = $1,007.09 so S = $407.09.

$600
𝑅𝑆 = .10 + (1 − .40)(.10 − .08) = 11.77%
$407.09
Step Three: Valuation

 Discount the cash flows to equity holders at RS =

11.77%
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

$96.20 $221.20 $346.20 $128.80

𝑁𝑃𝑉 = −$400 + + + −
(1.1177) (1.1177)2 (1.1177)3 (1.1177)4
𝑁𝑃𝑉 = $28.56
WACC Method
𝑆 𝐵
𝑅𝑊𝐴𝐶𝐶 = 𝑅 + 𝑅 (1 − 𝑇𝐶 )
𝑆+𝐵 𝑆 𝑆+𝐵 𝐵

 To find the value of the project, discount the

unlevered cash flows at the weighted average
cost of capital.
 Suppose Pearson’s target debt to equity ratio is
1.50
WACC Method

𝐵
1.50 = ∴ 1.5𝑆 = 𝐵
𝑆

𝐵 1.5𝑆 1.5 𝑆
= = = 0.60 = 1 − 0.60 = 0.40
𝑆 + 𝐵 𝑆 + 1.5𝑆 2.5 𝑆+𝐵

𝑅𝑊𝐴𝐶𝐶 = (0.40) × (11.77%) + (0.60) × (8%) × (1 − .40)

𝑅𝑊𝐴𝐶𝐶 = 7.58%
WACC Method

 To find the value of the project, discount the

unlevered cash flows at the weighted average
cost of capital
$125 $250 $375 $500
𝑁𝑃𝑉 = −$1,000 + + 2
+ 3
+
(1.0758) (1.0758) (1.0758) (1.0758)4

NPV7.58% = $6.68
A Comparison of the APV, FTE,
and WACC Approaches

 All three approaches attempt the same task:

valuation in the presence of debt financing.
 Guidelines:
– Use WACC or FTE if the firm’s target debt-to-value
ratio applies to the project over the life of the project.
– Use the APV if the project’s level of debt is known
over the life of the project.
 In the real world, the WACC is, by far, the most
widely used.
Summary: APV, FTE, and WACC

APV WACC FTE

Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing
effects Yes No No
Summary: APV, FTE, and WACC

Which approach is best?

 Use APV when the level of debt is not
constant
 Use WACC and FTE when the debt ratio is
constant
– WACC is by far the most common
– FTE is a reasonable choice for a highly levered
firm