5 - Valuation: Principles and methods

Abstract

This chapter discusses the principles and methods related to valuation. The capital cash flow valuation method is a simplified version of adjusted present value (APV). The free cash flow (FCF)–weighted average cost of capital (WACC) method values the whole firm. This method accounts for the tax shield of debt in the discount rate and therefore relies on several assumptions, such as constant cost of debt and equity and constant tax rate. These assumptions impose severe limitations on the method that does not take account of the benefit provided by financial execution, cannot easily incorporate some financial structures, cannot accommodate subsidized debt, and leads to important distortions for firms with high debt to equity (D/E) ratios and debt with significant prospects of default. Still valuing the entire firm, APV uses the same FCF as the FCF–WACC method, but instead of adjusting the discount rate to account for the interest tax shield, it calculates this tax shield as a separate component. In other words, APV separates the valuation exercise into one component associated with the project as if it were financed entirely with equity and the other made of the present value of all the effects associated with the project actual financing plan. The chapter discusses the links among management decisions, value drivers, and valuation results. By identifying and understanding the long-term levers of a company, a more focused behavior by managers with better strategic planning and outcomes can be expected.