CCF and ECF Valuation

Ashutosh Dash
 Fundamentals of FCFF
Depends on valuation components
Assets not being used in current operations,
or whose cash flows are not operating
should be valued separately
Cash Flows - The Starting Point
FCFF FCFE FCFD
EBIT (1-t) Net Income
Adjustments:
Depreciation + +
CAPEX (-) (-)
Changes in WC +/(-) +/(-)
Interest +
Principal - +
Repayment
New Debt + (-)
Proceed
FCFF, FCFE & FCFD - The Relation
Do you think FCFF = FCFE+FCFD ?

FCFF ≠ FCFE + FCFD or FCFF ≠ CCF

Why?
FCFF = EBIT (1-t) + Dep – Capex – Inc WC
FCFE+FCFD = NI + Int + Dep – Capex – Inc WC

FCFE+FCFD = CCF
EBIT (1-t) + Dep – Capex – Inc WC + Int (t)

Hence FCFE+FCFD = FCFF + Interest tax Shield

Fundamentals of CF valuation
Approach 1 Approach II

Unlevered Cash Flow Discounting

(FCFF) Factor
(Unlevered
WACC)
Levered Discounting Cash Flow
Factor (CCF)
(WACC)
CCF Method – The
Essentials
Capital Cash Flow Method
Unlevered Cost of Capital
Applying DCF Techniques – Word of
Caution
With low leverage,
◦ It does not matter whether one values equity
directly or as assets-minus-debt
◦ Equity may be evaluated directly, by
discounting expected equity cash flows at the
cost of equity

What if the leverage is high and the

amount of debt changes over time?
High levered Firm – The concerns
Though firm is solvent, default is more
likely
Valuing the assets is a bit trickier because
of more and riskier tax shields and high
cost of financial distress
ECF Method
An Illustration
Additional Information
 Salesfigure in Base year – 100Mn
 Cash Balance at 0 year end – 5M
 Financing

◦ Senior Debt 40Mn @ 10%

◦ Junior Debt 50Mn @ 15%
◦ Equity 13Mn
 LBO Fund invests 12Mn for 80% stake, rest by
management
 Cash Horizon 5 years
 Exit Multiple: 6-8*EBIT or 10-14 *P/E ratio
 Depreciation amount id invested for asset replacement
Income Statement - Projection
Cash Flow & Cash Account
Farm Capitalization
Terminal Value & IRR Analysis
Terminal Value & IRR Analysis
(II)
Equity Value with Target IRR
Equity Value, Enterprise Value and Price
Backward Induction Method
Formulas used in BI Method
EV based on Backward
Induction
 ECF Method – Pros and Cons
 Any DCF technique is flawed when debt is risky
 When debt is riskless, ECF produces correct value
 Still better in LBOs as the discount rate is high
 ECF
◦ Provides a biased estimate of firm value when debt is
risky,
◦ the sign of the bias is known, and
◦ the magnitude of the bias can be calculated
 WACC and APV - incorporate the promised tax
shield, rather than the expected tax shield