Strength: Reflects actual benefits that investors care about (cash flows) better than other methods. Weakness: Relies heavily on projections. Valuations are only as good as these projections!
Different DCF Methods
Net Present Value Approach
Discount Free Cash Flows at WACC.
Adjusted Present Value
Calculate the value of the all-equity firm, then add the present value of tax shields. Useful approach when leverage ratios are projected to change over time. This often occurs in buyouts.
Valuing Firms using Discounted Cash Flows
VF = PV(FCFT) + PV(TVT) + NOA VF = the value of the business PV(FCFT) = the present value of the total free cash flows from operations during the forecast period PV(TVT) = the present value of the total terminal or residual value at the end of the forecast period NOA = the market value of excess or non-operating assets (including assets that could be sold without affecting operations such as excess land, an extra building, etc.)
Valuing Firms Using Discounted Cash Flows
The total value of a firm also equals the sum of value of the claims against its cash flows.
where VD = the market value of debt and VE = the market value of the firm's equity.
VF = VD + VE
This suggests that the value of the equity claims against a firm can be calculated as: VE = VF - VD.
Taxes and WACC
If you discount using the WACC approach, cash flows have to be projected just as you would for a capital investment project.
Do not deduct interest. Calculate taxes as if the company were all-equity financed. The value of interest tax shields is picked up in the WACC formula.
The Weighted Average Cost of Capital (WACC) Formula
?D ? ?P ? ?E ? WACC = (1 ? Tc )? × rD ? + ? × rP ? + ? × rE ? V V V ? ? ? ? ? ?
Example - Sangria Corporation
Balance Sheet (Market Value, millions) Assets 125 50 25 50 Total assets 125 125
Debt Preferred Equity Common Equity Total liabilities
? ? View More »