International Journal of Management (IJM), OF ISSN MANAGEMENT 0976 6502(Print), ISSN (IJM 0976 ) INTERNATIONAL JOURNAL 6510(Online), Volume

me 4, Issue 2, March- April (2013) ISSN 0976-6502 (Print) ISSN 0976-6510 (Online) Volume 4, Issue 2, March- April (2013), pp. 63-77 IAEME: www.iaeme.com/ijm.asp Journal Impact Factor (2013): 6.9071 (Calculated by GISI) www.jifactor.com

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VALUING COMPANIES BY DISCOUNTED CASH FLOWS: 10 METHODS AND 1 SOLUTION

Nisarg A Joshi1, Jay Desai2, Arti Trivedi3
1 2

(M.B.A, Shri Chimanbhai Institute of Management & Research, Ahmedabad, Gujarat, India (M.B.A, Shri Chimanbhai Institute of Management & Research, Ahmedabad, Gujarat, India 3 (M.B.A, Shri Chimanbhai Institute of Management & Research, Ahmedabad, Gujarat, India

ABSTRACT This paper shows 10 valuation methods based on equity cash flow; free cash flow; capital cash flow; APV (Adjusted Present Value); business's risk-adjusted free cash flow and equity cash flow; risk-free rate-adjusted free cash flow and equity cash flow; economic profit; and EVA. All 10 methods always give the same value. This result is logical, as all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows or parameters taken as the starting point for the valuation. We present all ten methods, allowing the required return to debt to be different from the cost of debt. Seven methods require an iterative process. Only the APV and business risk-adjusted cash flows methods do not require iteration. Keywords: valuation, DCF, discounted cash flow, WACC, free cash flow 1. INTRODUCTION To value a company by cash flow discounting, we may use different cash flows, which will always have different risks and will require different discount rates. As in each case we are valuing the same company, we should get the same valuation, no matter which expected cash flows we use. In this paper we present ten different approaches to valuing companies by discounting cash flows. Although some authors argue that different methods may produce different valuations, we will show that all methods provide the same value under the same assumptions.

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) The most common method for valuing companies is the Free Cash Flow method. In that method, interest tax shields are excluded from the cash flows and the tax deductibility of the interest is treated as a decrease in the weighted average cost of capital (WACC). As the WACC depends on the capital structure, this method requires an iterative process: to calculate the WACC, we need to know the value of the company, and to calculate the value of the company, we need to know the WACC. Seven out of the ten methods presented require an iterative process, while only three (APV and the two business risk-adjusted cash flows methods) do not. The prime advantage of these three methods is their simplicity. Whenever the debt is forecasted in levels, instead as a percentage of firm value, the APV is much easier to use because the value of the interest tax shields is quite easy to calculate. The two business risk-adjusted cash flows methods are also easy to use because the interest tax shields are included in the cash flows. The discount rate of these three methods is the required return to assets and, therefore, it does not change when capital structure changes. Section 1 shows the 10 most commonly used methods for valuing companies by discounted cash flows: equity cash flows discounted at the required return to equity; free cash flow discounted at the WACC; capital cash flows discounted at the WACC before tax; APV (Adjusted Present Value); the business's risk-adjusted free cash flows discounted at the required return to assets; the business's risk-adjusted equity cash flows discounted at the required return to assets; 7. economic profit discounted at the required return to equity; 8. EVA discounted at the WACC; 9. the risk-free rate-adjusted free cash flows discounted at the risk-free rate; and 10. The risk-free rate-adjusted equity cash flows discounted at the required return to assets. All ten methods always give the same value. This result is logical, since all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as the starting point for the valuation. In section 2 the 10 methods and a theory are applied to an example. The theory is: 1) Fernandez (2007)[6] assumes that the company will have a constant debt-to-equity ratio in book value terms. In this scenario, the risk of the increases of debt is equal to the risk of the free cash flow. 2. LITERATURE REVIEW There is a considerable body of literature on the discounted cash flow valuation of firms. The main difference between all of these papers and the approach proposed in sections I and II is that most previous papers calculate the value of tax shields as the present value of the tax savings due to the payment of interest.
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1. 2. 3. 4. 5. 6.

International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Myers (1974)[18] introduced the APV (adjusted present value) method, but proposed calculating the VTS by discounting the tax savings (N T r) at the required return to debt (Kd). The argument is that the risk of the tax saving arising from the use of debt is the same as the risk of the debt. This approach has also been recommended in later papers in the literature, two being Taggart (1991)[22] and Luehrman (1997)[12]. One problem with the Myers (1974)[18] approach is that it does not always give a higher cost of equity than cost of assets and this hardly makes any economic sense. Harris and Pringle (1985)[9] propose that the present value of the tax saving due to the payment of interest should be calculated by discounting the interest tax savings (N T r) at the required return to unlevered equity (Ku), i.e. VTS = PV [Ku; N T r]. Their argument is that the interest tax shields have the same systematic risk as the firms underlying cash flows and, therefore, should be discounted at the required return to assets (Ku). Ruback (1995 and 2002)[19][20], Kaplan and Ruback (1995)[11], Brealey and Myers (2000, page 555)[23], and Tham and Vlez-Pareja (2001)[21], also claim that the appropriate discount rate for tax shields is Ku, the required return to unlevered equity. Ruback (1995 and 2002)[19][20] presents the Capital Cash Flow (CCF) method and claims that WACCBT = Ku. Based on this assumption, Ruback (1995 and 2002) [19][20] gets the same valuation as Harris and Pringle (1985)[9]. A large part of the literature argues that the value of tax shields should be calculated in a different manner depending on the debt strategy of the firm. Hence, a firm that wishes to keep a constant D/E ratio must be valued in a different manner from a firm that has a preset level of debt. Miles and Ezzell (1980)[13] indicate that for a firm with a fixed debt target (i.e. a constant [D/(D+E)] ratio), the correct rate for discounting the interest tax shields is Kd for the first year and Ku for the tax saving in later years. Inselbag and Kaufold (1997)[10] and Ruback (1995 and 2002) [19][20] argue that when the amount of debt is fixed, interest tax shields should be discounted at the required return to debt. However, if the firm targets a constant debt/value ratio, the value of tax shields should be calculated according to Miles and Ezzell (1980)[13]. Finally, Taggart (1991)[22] suggests using Miles & Ezzell (1985)[14] if the company adjusts to its target debt ratio once a year and Harris & Pringle (1985) [9] if the company adjusts to its target debt ratio continuously. Damodaran (1994, page 31)[3] argues that if all the business risk is borne by the equity, then the formula relating the levered beta (L) to the asset beta (u) is L = u + (D/E) u (1 T). This formula is exactly formula (29) assuming that d = 0. One interpretation of this assumption is (see page 31 of Damodaran, 1994)[3] that all of the firms risk is borne by the stockholders (i.e., the beta of the debt is zero). In some cases, it may be reasonable to assume that the debt has a zero beta, but then the required return to debt (Kd) should also be the risk-free rate. However, in several examples in his books Damodaran (1984 and 2002)[25] considers the required return to debt to be equal to the cost of debt, both of which are higher than the risk-free rate. Fernandez (2007)[6] shows that for a company with a fixed book-value leverage ratio, the increase of debt is proportional to the increases of net assets and the risk of the increases of debt is equal to the risk of the increases of assets. In that situation, when the debt value is equal to its book value, VTS0 = PV0 [Kut; Dt-1 Kut Tt]. This expression does not mean that the appropriate discount for tax shields is the unlevered cost of equity, since the amount being discounted is higher than the tax shields (it is multiplied by the unlevered cost of equity and not the cost of debt). This result arises as the difference of two present values. In the case of no growth perpetuities, equation (12) is VTS = DT. The value of tax shields being DT for no
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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) growth perpetuities is quite a standard result. It may be found, for example, in Bodie and Merton (2000)[24], Modigliani and Miller (1958 and 1963)[16,17], Myers (1974)[18], Damodaran (2002)[25] and Brealey and Myers (2000)[23]. In contrast, the Miller (1977)[15] view that T= 0 corresponds to a CAPM where the intercept is RF(1 TC). A similar eect can be seen in the formula for the required return on assets: It contains the most striking results of the valuation performed on the company according to Fernndez (2004)[4], Damodaran (1994)[3], Ruback (2002)[20] and Myers (1974)[18]. It may be seen that: 1) Equity value (E) grows with residual growth (g), except according to Damodaran (1994)[3]. 2) Required return to equity (Ke) decreases with growth (g), except according to Damodaran (1994)[3] and Ruback (2002)[20]. 3) Required return to equity (Ke) is higher than the required return to assets (Ku), except for Myers (1974)[18] when g > 5%. Please note that these exceptions are counterintuitive. 3. RESEARCH METHODOLOGY Ten discounted cash flow valuation methods Method 1: Using the expected equity cash flow (ECF) and the required return to equity (Ke). Equation (1) indicates that the value of the equity (E) is the present value of the expected equity cash flows (ECF) discounted at the required return to equity (Ke). E0 = PV0 [Ket; ECFt] (1)

The expected equity cash flow is the sum of all expected cash payments to shareholders, mainly dividends and share repurchases. Equation (2) indicates that the value of the debt (D) is the present value of the expected debt cash flows (CFd) discounted at the required return to debt (Kd). Dt is the increase in debt, and It is the interest paid by the company. CFdt = It - Dt D0 = PV0 [Kdt; CFdt] (2)

Definition of FCF: the free cash flow is the hypothetical equity cash flow when the company has no debt. The expression that relates the FCF with the ECF is: FCFt = ECFt - Dt + It (1 - T) The expected debt cash flow in a given period is given by equation (4) CFd t = Nt-1 rt - (Nt - Nt-1)
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(3)

(4)

International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Where N is the book value of the financial debt and r is the cost of debt. Nt-1 rt is the interest paid by the company in period t. (Nt - Nt-1) is the increase in the book value of debt in period t. When the required return to debt (Kd) is different than the cost of debt (r), then the value of debt (D) is different than its book value (N). Note that if, for all t, rt = Kdt, then N0 = D0. But there are situations in which rt > Kdt (i.e. if the company has old fixed-rate debt and interest rates have declined, or if the company can only get expensive bank debt), and situations in which rt < Kdt (i.e. if the company has old fixed-rate debt and interest rates have increased). Method 2: Using the free cash flow and the WACC (weighted average cost of capital). Equation (5) indicates that the value of the debt (D) plus that of the shareholders' equity (E) is the present value of the expected free cash flows (FCF) discounted at the weighted average cost of capital (WACC): E0 + D0 = PV0 [WACCt; FCFt] (5)

The free cash flow is the hypothetical equity cash flow when the company has no debt. The expression that relates the FCF with the ECF is: ECFt = FCFt + (Nt - Nt-1) - Nt-1 rt (1 - Tt ) (6)

Definition of WACC: the WACC is the rate at which the FCF must be discounted so that equation (5) gives the same result as that given by the sum of (1) and (2). By doing so, the WACC is (7): WACCt = [Et-1 Ket + Dt-1 Kdt (1-T)] / [Et-1 + Dt-1] (7)

T is the tax rate used in equation (3). Et-1 + Dt-1 are neither market values nor book values: in actual fact, Et-1 is the value obtained when the valuation is performed using formulae (1) or (4). Consequently, the valuation is an iterative process: the free cash flows are discounted at the WACC to calculate the company's value (D+E) but, in order to obtain the WACC; we need to know the company's value (D+E). Some authors, one being Luehrman (1997)[12], argue that equation (4) does not give us the same result as is given by the sum of (1) and (2). That usually happens as a result of an error in calculating equation (6), which requires using the values of equity and debt (Et-1 and Dt-1) obtained in the valuation. The most common error when calculating the WACC is to use book values of equity and debt, as in Luehrman (1997)[12] and in Arditti and Levy (1977)[1]. Other common errors when calculating WACCt are: - Using Et and Dt instead of Et-1 and Dt-1. - Using market values of equity and debt, instead of the values of equity and debt (Et-1 and Dt-1) obtained in the valuation.

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Method 3: Using the capital cash flow (CCF) and the WACCBT (weighted average cost of capital, before tax). The capital cash flows are the cash flows available for all holders of the company's securities, whether these be debt or shares, and are equivalent to the equity cash flow (ECF) plus the cash flow corresponding to the debt holders (CFd). Equation (8) indicates that the value of the debt today (D) plus that of the shareholders' equity (E) is equal to the capital cash flow (CCF) discounted at the weighted average cost of capital before tax (WACCBT). E0 + D0 = PV[WACCBTt; CCFt] (8)

Ruback (2002)[20] also proves in a different way that the CCF methos is equivalent to FCF method. Therefore the expression WACCBT shows the rate at which the CCF must be discounted so that equation gives the same result as that given by the sum of (1) and (2). WACCBT t = [Et-1 Ket + Dt-1 Kdt] / [Et-1 + Dt-1] The expression that relates the CCF with the ECF and the FCF is (9): CCFt = ECFt + CFdt = FCFt + It T. Dt = Dt - Dt-1 ; It = Dt-1 Kdt (10) (9)

Method 4: Adjusted present value (APV) Equation (11) indicates that the value of the debt (D) plus that of the shareholders' equity (E) is equal to the value of the unlevered company's shareholders' equity, Vu, plus the value of the tax shield (VTS): E0 + D0 = Vu0 + VTS0 (11)

Ku is the required return to equity in the debt-free company. Vu is given by (12). Ku is the required return to equity in the debt-free company (also called the required return to assets). Vu0 = PV0 [Ku t ; FCFt ] (12)

Most descriptions of the APV suggest calculating the VTS by discounting the interest tax shields using some discount rate. Myers (1974)[18], Taggart (1991)[22] and Luehrman (1997)[12] propose using the cost of debt (based on the theory that tax shields are about as uncertain as principal and interest payments). However, Harris and Pringle (1985) [9], Kaplan and Ruback (1995)[11], Brealey and Myers (2000)[23] and Ruback (2002)[20] propose using the required return to the unlevered equity as the discount rate.4 Copeland, Koller and Murrin (2000)[2] assert that the finance literature does not provide a clear answer about which discount rate for the tax benefit of interest is theoretically correct. They further conclude we leave it to the readers judgment to decide which approach best fits his or her situation.
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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Fernndez (2004)[4] shows that the value of tax shields is the difference between the present values of two different cash flows, each with its own risk: the present value of taxes for the unlevered company, and the present value of taxes for the levered company. Following Fernndez (2007)[6], the value of tax shields without cost of leverage is: Method 5: Using the business risk-adjusted free cash flow and Ku (required return to assets). Equation (13) indicates that the value of the debt (D) plus equity (E) is the present value of the expected business risk-adjusted free cash flows (FCF\\Ku), discounted at the required return to assets (Ku): E0 + D0 = PV0 [Kut ; FCFt\\Ku] The definition of the business risk-adjusted free cash flows (FCF\\Ku) is (14): FCFt\\Ku = FCFt - (Et-1 + Dt-1) [WACCt - Kut ] (14) (13)

Method 6: Using the business risk-adjusted equity cash flow and Ku (required return to assets). Equation (15) indicates that the value of the equity (E) is the present value of the expected business risk-adjusted equity cash flows (ECF\\Ku) discounted at the required return to assets (Ku): E0 = PV0 [Kut; ECFt \\Ku] The definition of the business risk-adjusted equity cash flows (ECF\\Ku) is (16): ECFt\\Ku = ECFt - Et-1 [Ket - Kut ] Method 7: Using the economic profit and Ke (required return to equity). Equation (17) indicates that the value of the equity (E) is the equity's book value (Ebv) plus the present value of the expected economic profit (EP) discounted at the required return to equity (Ke). E0 = Ebv0 + PV0 [Ket; EPt] (17) (16) (15)

The term economic profit (EP) is used to define the accounting net income or profit after tax (PAT) less the equity's book value (Ebvt-1) multiplied by the required return to equity. EPt = PATt - Ke Ebvt-1 (18)

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013)
Method 8: Using the EVA (economic value added) and the WACC (weighted average cost of capital). Equation (19) indicates that the value of the debt (D) plus equity (E) is the book value of equity and the debt (Ebv0+ N0) plus the present value of the expected EVA, discounted at the WACC: E0 + D0 = (Ebv0+ N0) + PV0 [WACCt; EVAt] (19)

The EVA (economic value added) is the NOPAT (Net Operating Profit After Tax) less the company's book value (Dt-1 + Ebvt-1) multiplied by the weighted average cost of capital (WACC). The NOPAT (Net Operating Profit After Taxes) is the profit of the unlevered company (debt-free). EVAt = NOPATt - (Dt-1 + Ebvt-1) WACC t Method 9: Using the risk-free-adjusted free cash flows discounted at the risk-free rate Equation (21) indicates that the value of the debt (D) plus equity (E) is the present value of the expected risk-free-adjusted free cash flows (FCF\\ RF), discounted at the risk-free rate (RF): E0 + D0 = PV0 [RF t ; FCFt\\RF] The definition of the risk-free-adjusted free cash flows (FCF\\RF) is (22): FCFt\\RF = FCFt - (Et-1 + Dt-1) [WACCt - RF t ] Method 10: Using the risk-free-adjusted equity cash flows discounted at the risk-free rate Equation (23) indicates that the value of the equity (E) is the present value of the expected riskfree-adjusted equity cash flows (ECF\\RF) discounted at the risk-free rate (RF): E0 = PV0 [RF t; ECFt \\RF] The definition of the risk-free-adjusted equity cash flows (ECF\\RF) is (24) ECFt\\RF = ECFt - Et-1 [Ket - RF t ] (24) (23) (22) (21) (20)

We could also talk of an eleventh method; using the business risk-adjusted capital cash flow and Ku (required return to assets), but the business risk-adjusted capital cash flow is identical to the business risk-adjusted free cash flow (CCF\\Ku = FCF\\Ku). Therefore, this method would be identical to Method 5. We could also talk of a twelfth method; using the risk-free-adjusted capital cash flow and RF (risk-free rate), but the risk-free-adjusted capital cash flow is identical to the risk-free-adjusted free cash flow (CCF\\RF = FCF\\RF). Therefore, this method would be identical to Method 9.

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) 4. SAMPLE DATA & ANALYSIS The fictitious company NJ Inc. has the balance sheet and income statement forecasts for the next few years shown in Table II. After year 3, the balance sheet and the income statement are expected to grow at an annual rate of 3%. Although the statutory tax rate is 40%, the effective tax rate will be zero in year 1 because the company is forecasting losses, and 36.36% in year 2 because the company will offset the previous years losses. The cost of debt (the interest rate that the bank will charge) is 9%. Using the balance sheet and income statement forecasts in Table II, we can readily obtain the cash flows given at the bottom of Table II. Table III contains the valuation of the company NJ Inc. using the ten methods described in Section I. The unlevered beta (u) is 1. The risk-free rate is 6%. The cost of debt (r) is 9%, but the company feels that it is too high. The company thinks that the appropriate required return to debt (Kd) is 8%. The market risk premium is 4%. Consequently, using the CAPM, the required return to assets is 10%. As the cost of debt (r) is higher than the required return to debt (Kd), the value of debt is higher than its nominal value. The value of debt also fulfils equation. The first method used is the APV because it does not require an iterative process and, therefore, is easier to implement. To calculate the value of the unlevered equity and the value of tax shields, we only need to compute two present values using Ku (10%) is the enterprise value and the equity value. Next is the calculation of the equity value as the present value of the expected equity cash flows. Please note that they are calculated through an iterative process because for equation (15) we need to know the result of equation (1), and for equation (1) we need to know the result of equation (15). The equity value in lines 8 and 6 is exactly the same. Next is the WACC according to equations (8), (14) and (19). Then there is the calculation of the equity value as the present value of the expected free cash flows minus the debt value. They are also calculated through an iterative process because for equations (8) and (19) we need to know the result of equation (7), and for equation (7) we need to know the result of equation (8) or (19). Please note that in year 1 WACC = Ku = 10% because the effective tax rate is zero. The equity value is exactly the same. Next is the WACCBT according to equation (9). Thereafter is the calculation of the equity value as the present value of the expected capital cash flows minus the debt value. They are also calculated through an iterative process because for calculating the WACCBT we need to know the equity value and vice-versa. Note that in year 1 WACCBT = WACC = Ku = 10% because the effective tax rate is zero. Next Line is the expected residual income according to equation. Next line is the calculation of the equity value as the present value of the expected residual income plus the book value of equity. They are calculated through an iterative process because for calculating the residual income we need to know the required return to equity, and for this, we need the equity value. Then the expected businesss risk-adjusted equity cash flows will be calculated. It is the calculation of the equity value as the present value of the expected businesss riskadjusted equity cash flows. As the present value is calculated using Ku (10%), there is no need for an iterative process. Next is the expected businesss risk-adjusted free cash flows according. It is the calculation of the equity value as the present value of the expected businesss risk-adjusted free cash flows minus the value of debt. As the present value is calculated using Ku (10%), there is no need for an iterative process.
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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Next line is the expected risk-free-adjusted equity cash flows according to equation. It is the calculation of the equity value as the present value of the risk-free rate adjusted equity cash flows. They are calculated through an iterative process because for calculating the riskfree-adjusted equity cash flows we need to know the required return to equity, and for that, we need the equity value. Finally it is the expected risk-free-adjusted free cash flows according to equation. Next is the calculation of the equity value as the present value of the risk free rate-adjusted free cash flows minus the debt value. They are calculated through an iterative process because for calculating the risk-free-adjusted free cash flows we need to know the WACC, and for that, we need the equity value. 5. RESULTS The method for calculating the company using cash flow is given in Table. 1. The figures of forecasted profit and loss account of a fictitious company NJ Inc. is given in Table 2. Finally, the valuation of NJ Inc. using 10 methods is given in Table 3. Table I: Ten Valuation Methods Method 1 2 3 4 Cash Flow ECF (Equity Cash Flow) CFd (Debt Cash Flow) FCF (Free Cash Flow) CCF (Capital Cash Flows) FCF (Free Cash Flow) D T Ku 5 6 7 8 9 10 RI (Residual Income) EVA (Economic Value Added) FCF//ku (Business riskadjusted free cash flow) ECF//ku (Business riskadjusted equity cash flow) FCF//Rf (Risk free-adjusted free cash flow) ECF//Rf (Risk free-adjusted equity cash flow) Discount Rate Ke (Cost of Levered Equity) Kd( Required Return to Debt) WACC WACCBT (Weighted Average Cost of Capital Before Taxes) Ku (Cost of unlevered equity) Ku (Cost of unlevered equity) Ke WACC Ku Ku Rf Rf Value E (Equity) D (Debt) E+D E+D Vu (Unlevered Equity) VTS (Value of Tax Shields) E Ebv E + D Ebv N E+D E E+D E

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Table II: Balance Sheet and Income Statement Forecasts of NJ Inc. Balance Sheet Working Capital Requirements Gross Fixed Assets Accumulated Depriciation Net Fixed Assets TOTAL ASSETS Debt Equity (Book Value) TOTAL LIABILITIES Income Statement EBIDTA Depriciation Interest Payments PBT Taxes PAT Taxes Cash Flows PAT Depreciation Increase of Debt Increase in Working Capital Investment in Fixed Assets ECF (Equity Cash Flow) FCF (Free Cash Flow) CFd (Debt Cash Flow) CCF (Capital Cash Flow) 0 800 1,200 1 890 1,300 -200 1,100 1,990 1,500 490 1,990 1 325 200 135 -10 0 -10 0% 1 -10 200 0 -90 -100 0 135 135 135 2 1,000 1,450 -405 1,045 2,045 1,500 545 2,045 2 450 205 135 110 40 70 36.36% 2 70 205 0 -110 -150 15 100.91 135 150 3 1,100 1,660 -615 1,045 2,145 1,550 595 2,145 3 500 210 135 155 62 93 40% 3 93 210 50 -100 -210 43 74 85 128 4 5

1,200 2,000 1,500 500 2,000

1,133 1,166.99 1,895.10 2,134.90 -818.2 1,026.20 1,076.90 1,108.70 2,209.90 2,275.69 1,597 1,644.40 612.9 631.29 2,209.90 2,275.69 4 515 216.3 139.5 159.2 63.68 95.52 40% 4 95.52 216.3 46.5 -33 -235.1 90.22 127.42 93 183.22 5 530.45 222.79 142.29 165.37 66.15 99.22 40% 5 99.22 222.79 47.9 -33.99 -239.8 96.12 133.59 94.39 190.51

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) Table III: Valuation of NJ Inc.

Formula Ku D = PV(Kd; CFd) Vu = PV (Ku; FCF) VTS = PV[Ku; D T Ku + T (Nr - DKd)] E + D = VTS + Vu E = VTS + Vu D Ke E = PV(Ke; ECF) WACC E = PV(WACC; FCF) D WACCBT E = PV(WACCBT; CCF) D RI E = PV(Ke; RI) + Ebv EVA E = Ebv - (D-N) + PV(WACC; EVA) ECF//Ku E = PV(Ku; ECF//Ku) FCF//Ku E = PV(Ku; FCF//Ku) D ECF//RF E = PV(RF; ECF//RF) FCF//RF E = PV(RF; FCF//RF) D

0 1,743.73 1,525.62 762.09 2,287.71 543.98

10.00% 10.00% 10.00% 10.00% 10.00% 1,748.23 1,753.09 1,808.33 1,844.50 1,881.39 1,543.18 1,596.59 1,682.25 1,715.90 1,750.21 838.3 860.33 878.33 895.9 913.82 2,381.48 2,456.92 2,560.58 2,611.80 2,664.03 633.25 703.83 752.25 767.29 782.64 16.41% 633.25 10% 633.25 10% 13.51% 703.83 7.41% 703.83 9.47% 703.83 3.78 703.83 8.55 703.83 -7.25 703.83 162.71 703.83 -32.58 703.83 67.46 703.83 12.99% 752.25 7.23% 752.25 9.43% 752.25 22.21 752.25 26.12 752.25 21.95 752.25 142.02 752.25 -6.19 752.25 43.75 752.25 12.88% 767.29 7.26% 767.29 9.44% 767.29 17.12 767.29 21.84 767.29 60.18 767.29 204.85 767.29 30.09 767.29 102.42 767.29 12.88% 782.64 7.26% 782.64 9.44% 782.64 17.46 782.64 22.28 782.64 61.38 782.64 208.94 782.64 30.69 782.64 104.47 782.64

543.98

543.98

543.98

633.25 -92.05 633.25 -75

543.98

543.98

633.25 -34.87 633.25 135 633.25 -56.63 633.25 43.49 633.25

543.98

543.98

543.98

543.98

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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) 6. CONCLUSION The paper shows that ten commonly used discounted cash flow valuation methods always give the same value. This result is logical, since all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as the starting point for the valuation. We present all ten methods, allowing the required return to debt to be different from the cost of debt. Seven methods require an iterative process. Only APV and the business risk adjusted cash flows methods do not require iteration; that makes them the easiest methods to use. The relevant tax rate is not the statutory tax rate, but the effective tax rate applied to earnings in the levered company on each year. The value of tax shields is not the present value of tax shields using either the cost of equity or debt to discount the tax write-offs. It is the difference between the present values of two different cash flows, each with its own risk: the present value of taxes for the unlevered company and the present value of taxes for the levered company. Abbreviations d = Beta of debt L = Beta of levered equity u = Beta of unlevered equity = beta of assets D = Value of debt E = Value of equity Ebv = Book value of equity ECF = Equity cash flow ECF//Ku = business risk-adjusted equity cash flows ECF//RF = expected risk-free-adjusted equity cash flows RI = Residual income EVA = Economic value added FCF = Free cash flow FCF//Ku = business risk-adjusted free cash flows FCF//RF = risk-free-adjusted free cash flows g = Growth rate of the constant growth case I = Interest paid Ku = Cost of unlevered equity (required return to unlevered equity) Ke = Cost of levered equity (required return to levered equity) Kd = Required return to debt N = Book value of the debt NOPAT = Net Operating Profit After Tax = profit after tax of the unlevered company PAT = Profit after tax PBT = Profit before tax PM = Market premium = E (RM - RF) PV = Present value r = Cost of debt RF = Risk-free rate RM = Market return
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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) ROA = Return on Assets = NOPATt / (Nt-1+Ebvt-1) ROE = Return on Equity = PATt / Ebvt-1 T = Corporate tax rate VTS = Value of the tax shields Vu = Value of shares in the unlevered company WACC = Weighted average cost of capital WACCBT = Weighted average cost of capital before taxes WCR = Working capital requirements = net current assets REFERENCES [1]. Arditti, F.D. and H. Levy (1977), "The Weighted Average Cost of Capital as a Cutoff Rate: A Critical Examination of the Classical Textbook Weighted Average", Financial Management (Fall), pp. 24-34. [2]. Copeland, T.E., T. Koller and J. Murrin (2000), Valuation: Measuring and Managing the Value of Companies. Third edition. New York: Wiley. [3]. Damodaran, A (1994), Damodaran on Valuation, John Wiley and Sons, New York. [4]. Fernandez, P. (2004), "The value of tax shields is NOT equal to the present value of tax shields", Journal of Financial Economics, Vol. 73/1 (July), pp. 145-165. [5]. Fernandez, P. (2007). "A More Realistic Valuation: APV and WACC with constant book leverage ratio", Journal of Applied Finance, Fall/Winter, Vol.17 No 2, pp. 13-20. [6]. Fernandez, P. (2007b), "Equity Premium: Historical, Expected, Required and Implied" [7]. Fernandez, P. (2008), Equivalence of Ten Different Methods for Valuing Companies by Cash Flow Discounting, International Journal of Finance Education, Vol. 1 Issue 1, pp. 141-168. 2005. [8]. Fernandez, P. (2002), Valuation Methods and Shareholder Value Creation. (Academic Press, San Diego, CA.). [9]. Harris, R.S. and J.J. Pringle (1985), "Risk-Adjusted Discount Rates Extensions form the Average-Risk Case", Journal of Financial Research (Fall), pp. 237-244. [10]. Inselbag, I. and H. Kaufold (1997), "Two DCF Approaches for Valuing Companies under Alternative Financing Strategies (and How to Choose Between Them)", Journal of Applied Corporate Finance (Spring), pp. 114- 122. [11]. Kaplan, S. and R. Ruback (1995), "The Valuation of Cash Flow Forecasts: An Empirical Analysis", Journal of Finance, Vol 50, No 4, September. [12]. Luehrman, T. A. (1997), "What's It Worth: A General Manager's Guide to Valuation", and "Using APV: A Better Tool for Valuing Operations", Harvard Business Review, (MayJune), pp. 132-154. [13]. Miles, J.A. and J.R. Ezzell (1980), "The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification," Journal of Financial and Quantitative Analysis (September), pp. 719-730. [14]. Miles, J.A. and J.R. Ezzell, (1985), "Reequationing Tax Shield Valuation: A Note", Journal of Finance, Vol XL, 5 (December), pp. 1485-1492. [15]. Miller, M. H. (1977), "Debt and Taxes", Journal of Finance (May), pp. 261-276. [16]. Modigliani, F. and M. Miller (1958), "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review 48, 261-297.
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International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 6510(Online), Volume 4, Issue 2, March- April (2013) [17]. Modigliani, F. and M. Miller (1963), "Corporate Income Taxes and the Cost of Capital: A Correction", American Economic Review (June), pp. 433-443. [18]. Myers, S.C. (1974), "Interactions of Corporate Financing and Investment Decisions Implications for Capital Budgeting", Journal of Finance (March), pp. 1-25. [19]. Ruback, R. S. (1995), "A Note on Capital Cash Flow Valuation", Harvard Business School, 9-295-069. [20]. Ruback, R. (2002), "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows", Financial Management 31, pp. 85-103. [21]. Tham, J. and I. Vlez-Pareja (2001), "The Correct Discount Rate for the Tax Shield: the N-period Case", SSRN Working Paper. [22]. Taggart, Robert A, 1991, Consistent valuation and cost of capital expressions with corporate and personal taxes, Financial Management, Autumn 1991, 8-20. [23]. Brealey, Richard A and Stewart C Myers, 2000, Principles of Corporate Finance, McGraw-Hill. [24]. Bodie, Z., Merton, R.C. (2000), Finance, Prantice Hall, Upper Saddle River, NJ. [25]. Damodaran, A. (2002), Investment Valuation. (John Wiley and Sons, New York, second edition). [26]. V.Anandavel and Dr.A.Selvarasu, Economic Value Added Performance of BSE-Sensex Companies Against its Equity Capital International Journal of Management (IJM), Volume 3, Issue 2, 2012, pp. 108 - 123, ISSN Print: 0976-6502, ISSN Online: 0976-6510.

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