Finance for International Business

A Review of Basic Valuation Techniques

A good understanding of valuation methods is essential before we can discuss valuation in an international context. The following exercises are a refresher.

Objective: To illustrate the equivalence of various valuation methods.

Consider a firm as follows: Assume that the firm has no debt. The cashflows are received at the end of each year and are perpetual. Cost of equity capital for an unlevered firm, r₀ , is 20%. The first cash-flow will be received one year from today. All calculations for valuation are done today. Firm value is defined as collective value of debt and equity.

Sales $ 500,000

Cash Costs 360,000

________

Operating Income 140,000

Tax @ 34% -47,600

________

Unlevered cash flow (UCF) $ 92,400

Find the firm value, using

a) APV method $__________.

b) FTE method $__________.

c) WACC method $__________.

Now assume that the firm has $126,229.50 of debt. Interest rate on debt is 10%

Find the firm value using

d) APV method $__________.

e) FTE method $__________.

f) WACC method $__________.

________________________________________________________________________

Objective: To illustrate that financing has no impact on firm value if there are no taxes (i.e. financing affects firm value purely because the interest payments generate tax-savings), and to further illustrate the equivalence of various valuation methods.

Assume the the firm has $ 100,000 of debt @ 10% and the tax rate is zero.

Find the firm value using

g) APV method $__________.

h) FTE method $__________.

i) WACC method $__________.

Assume the the firm has $ 200,000 of debt @10% and the tax rate is zero.

Find the firm value using

j) APV method $__________.

k) FTE method $__________.

l) WACC method $__________.

Notes:

1) Depreciation, amortization and capital expenditures were left out for simplicity. These considerations will affect operating income; and will therefore affect value,but the rest of the analysis will be conceptually unchanged.

2) Changes in working capital will occur if there is growth, these will affect UCF (and value). We left these out because we assumed no growth, for simplicity.

3) Our leverage was constant across time; as a result we were able to use a constant WACC. If we change leverage (for example, paying off debt or adding on more) we need to adjust WACC. This is operationally difficult beacuse of the circularity (to find Value we need to know WACC and to find WACC we need to know the Value). This is where the APV method is useful. APV explicitly relies on the fact that firm value depends on financing only to the extent of the tax impact of financing. In any event, all methods -when properly applied- must provide the same answer.

Suggested Reference: Corporate Finance- Ross, Westerfield and Jaffe, 1993, pp 493-502.