As one might expect, valuations can often become complex. The subject of the proper discount rate has spawned numerous books itself. Valuation can also bring up contentious issues, particularly when the ownershipinterest represents a controlling stake or there is a less than liquid market for that interest.

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The definition of a discounted cash flow (DCF) is a valuation method used to value an investmentopportunity. Discounted cash flow analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital. It also incorporates judgments of the uncertainty of the future cash flows.

Use the following formula to calculate Enterprise Value:

Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t

Or use constant-growth free cash flowvaluation model when free cash flow grows at a constant rate g. The free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).

Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid. Necessary investments in working and fixed capital have also been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.

Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.

For example, a company is projected to have fluctuating cash flows. Losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5… How much is it worth today?

Discount the cash flows at a rate acceptable to the investor – 18%.

Time Year 1 Year 2 Year 3 Year 4 Year 5 NPV
Projected future cash flow -10,000 -10,000 20,000 45,000 55,000
Residual value 5,000
Projected annual free cash flow -10,000 -10,000 20,000 45,000 60,000
Discounted cash flows - 8,475 -7,182 12,173 23,211 26,227 45,953

This leaves a present value of $45,953. In conclusion, it indicates the estimated fair market value of the company today.

Discounted Cash Flow Analysis Applications

DCF valuation method used to estimate the attractiveness of an investmentopportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be a good one.

Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. For example, small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations. This is because the inputs that produce these valuations are always changing and susceptible to error.

Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose is to account for the loss of economic efficiency of an investor due to risk. Investors use this rate because it provides a way to account and compensate for their risk when choosing an investment. Furthermore, this provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost, still include it to add a real-world element to financial calculations. It is a measure used to prevent one from becoming “calculator rich” without actually increasing personal wealth.

A succinct Discount Rate formula does not exist; however, it is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. The two following formulas provide a discount rate:

First, there is the following Weighted Average Cost of Capital formula.

If: E = $10,000 D = $10,000 C_{e} = $2,000 C_{d} = $1,000 V = $20,000 T = 30%

For APV:

APV = $1,000,000 + $50,000 = $1,050,000

If: NPV = $1,000,000 PV of the impact of financing = $50,000

Discount Rate Example

For example, Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. But she first needs to prove herself in the professional world.

Donna’s boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.

Donna’s boss gives Donna the financial information she needs for one venture. She finds the discount rate (risk) using the following equation:

If: E = $10,000 D = $10,000 C_{e} = $2,000 C_{d} = $1,000 V = $20,000 T = 30%

Next, Donna’s boss has her find the discount rate for another venture that he is involved in. The results are below:

Adjusted Present Value = NPV + PV of the impact of financing

Where: NPV = Net Present Value PV = Present Value

Donna appreciates her experience with her employer. As a result, she is sure that with this experience she can find the path to mentor another just like her.

How do you value a company and its equity? How do you calculate a company’s fair value? Have you overvalued or undervalued your company? As we dive into our companyvaluation introduction, we are going to look at the following are the three approaches to valuation:

The most fundamental approach is DCF approach, which extends the present value principles to analyze projects to value a company. The following four factors determine the value of a company:

Others are used to compare stocks within an industry sector

Comparable Transactions

Comparable transactions approach of valuing a company involves using a price multiple to evaluate whether an asset is relatively fairly valued, or undervalued, or overvalued when looked at the comparable transactions that have taken place in the industry and compared to a benchmark value of the multiple.

Adjusted present value (APV), defined as the net present value of a project if financed solely by equity plus the present value of financing benefits, is another method for evaluating investments. It is very similar to NPV. The difference is that is uses the cost of equity as the discount rate rather than WACC. And APV includes tax shields such as those provided by deductible interests. APV analysis is effective for highly leveraged transactions.

Adjusted Present Value Explanation

The adjusted present value approach is very similar to the Discounted Cash Flow method of valuation. So similar, in fact, that they will yield approximately the same results if the financing structure of a company is consistent. The method is especially effective in any situation in which the tax implications of a deal heavily effect the outcome, such as with a leveraged buyout. When compared to the more common methods of valuation, the adjusted present value method is newly created.

When valuing your company, it’s important to identify the destroyers in your company.

In the adjusted preset value (APV) approach the value of the firm is estimated in following steps.

1. The first step is to estimate the value of a company with no leverage by calculating a NPV at the cost of equity as the discount rate.

2. The next step is to calculate the expected tax benefit from a given level of debt financing. These can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the tax effects. The NPV of the tax effects is then added to the base NPV.

3. The last step is to evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt, and the expected cost of bankruptcy.

In the adjusted present value (APV) approach, the primary benefit of borrowing is a tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy.

If: Investment = $500,000 Cash flow from equity = $25,000 Cost of equity = 20% Cost of Debt = 7% Interest on debt = 7% Tax = 35% Finance the deal half with equity and half with debt

NPV = -$500,000 + ($25,000 / 20%) = -$375,000 PV = (35% x $250,000 x 7%) / 7% = $87,500

-$375,000 + $87,500 = -$287,500 –> Bad Deal

APV Valuation vs Cost of Capital

In an APV valuation, obtain the value of a levered firm by adding the net effect of debt to the un-levered firm value.

In the cost of capital approach, the effects of leverage show up in the cost of capital, with the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both the levered beta and the pre-tax cost of debt.

These two approaches can get the identical results in theory. The first reason for the differences is that the models consider bankruptcy costs very differently, with the adjusted present value approach providing more flexibility in considering indirect bankruptcy costs whether or not it shows up in the pre-tax cost of debt. So the APV approach will yield a more conservative estimate of value. The second reason is that the APV approach considers the tax benefit from a dollar debt value, usually based upon existing debt. The cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future. Download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

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