Types of Valuation :
1) Relative Valuation technique (also called the method of comparable)
2) Option-based Valuation technique (valuation contingent upon an event)
3) Absolute Valuation technique employing the discounted cash flow analysis
Assets = Liability
Fixed Assets + Cash = Debt + Equity
Fixed Assets = (Debt – Cash) + Equity
Fixed Assets = Net Debt + Equity
Debt Holders + Equity holders = Assets of the company
In its simplest form, the debt and the equity holders finance assets, the assets, in turn, generate a
cash flow for the company. So the cash generated by the company belongs to both these funders
in proportion to their funding.
The point to note here is that the cash generated belongs to the company, i.e., the Debt + Equity
funders. The cash that belongs to the company is called ‘The free cash flow to the firm’ (FCFF).
Or, from the free cash flow to the firm, you can deduct whatever cash is supposed to go to the
debt holders and value only the cash flow that belongs to the equity holders, and that is called the
‘Free cash flow to Equity (FCFE).
FCFF = Free Cash Flow to Firm ----Discounted at WACC in DCF
FCFE = Free Cash Flow to Equity ---- Discounted at “Cost of Equity” (Re) in DCF
1) FCFF = PAT + Depreciation + Amortisation + Deffered Tax – Change in Working Capital –
Investment in Fixed Assets “CAPEX” + Interest x (1-Tax)
2) FCFF = EBIT – EBIT x Tax + Depreciation + Amortisation + Deffered Tax – Change in
Working Capital – Investment in Fixed Assets “CAPEX”
FCFF = EBIT(1 - Tax) + Depreciation + Amortisation + Deffered Tax – Change in Working
Capital – Investment in Fixed Assets “CAPEX
3) FCFE = FCFF – Interest (1 - Tax) + (Total Debt Issued – Total Debt Repaid)
FCFE = FCFF – Interest (1 - Tax) + Net Debt
FCFF & FCFE are two methods to calculate Free Cash Flow depending upon from who’s
Perspective the Valuation is to be done, from Firm’s Perspective or Equity Holder’s Perspective.
After this calculation, it is brought back to Net Present Value using DCF model with Discount rate
of WACC (FCFF) or Re (FCFE). Now what is “WACC” & “Re” Discounting Rate in DCF, keep
reading…
Return expectations : Combined (WACC –> Debt Holder + Equity Holder)
We now have a broad overview of how to calculate the free cash flow to the firm and the free cash
flow to equity holders. Let’s quickly understand the return expectation from the firm and equity
holder’s perspective.
To get a sense of the return expectation of the firm, we should be clear about what the debt
holders expect. The debt holders of the firm, as we discussed earlier, expect an interest payment
against the principal amount, plus at the end of the tenure, they expect the principal itself to be
repaid.
The firm has to satisfy the debt holders’ return expectations. But the firm also has equity holders,
who will have a different return expectations. So when you are thinking about the firm’s free cash
flow, then because the firm has both debt and equity holders, the return expectation of the firm
should be such that it satisfies both debt and equity holders. If you build a valuation model based
on FCFF, the cash flow is discounted with a blended rate, satisfying both the debt and equity
holders.
Let me give you an example. Assume a company has 300Cr, of which debt is 100Crs, and the
equity holders fund the balance 200Cr. The debt holders expect a 9% return, and the equity
holders expect a 15% return. Why they expect what they expect is something we will discuss later.
However, from the company’s point of view, it should generate a blended return to satisfy both,
i.e., the expectation of the firm is the weighted average return –
WACC = Weighted Average Cost of Capital
WACC = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of Equity)
WACC = 100/300 x 9% + 200/300 x 15%
= 33.33% x 9% + 66.66% x 15%
= 13%
The blended rate of return is also called the ‘Weighted Average Cost of Capital (WACC).
Effective Cost of Debt
The Cost of Debt to the Company will be lowered due to Tax benefit called as Tax Shield
=== Effective Cost of Debt = Cost of Debt (1-Tax)
WACC = (Weight of Debt x Effective Cost of Debt) + (Weight of Equity x Cost of Equity)
In the previous Example : Effective Cost of Debt = 9% (1-25%) = 6.75 %
WACC = 100/300 x 9%(1-25%) + 200/300 x 15%
WACC = 100/300 x 6.75% + 200/300 x 15%
WACC = 12.24% (Considering Effective Cost of Debt while calculating WACC)
Return Expectation of Equity Holder (Re -> Equity Holder)
Think about the equity holder’s return expectation. The equity holders will expect a higher return
than the debt holders because the equity holders take more risk. Equity holders expect at least the
risk-free rate that prevails in the economy plus a risk premium for the additional risk (over the debt
holders) that they take. The return expectation of equity holders is called, ‘The cost of capital’.
Re = Cost of capital = Risk-free rate + Risk premium
Note that the cost of capital (Re) is always higher than the WACC
Market Risk Premium
You can think about it this way: if the risk-free rate (Rf) is 7%, how much more would you like (over
and above the risk-free rate) so that you feel encouraged to invest in equities? If you were to ask a
bunch of investors and take an average of the expected return, you would arrive at the rate.
However, most individual investors won’t have access to such a consensus. Hence we can
probably apply an equation to get our answer.
Re = Risk free rate (Rf) + Risk premium
Where Re = Return expectation of equity holders.
The risk premium is the additional return over and above the risk-free return to encourage an
investor to invest in equities. The risk premium is –
Risk premium = β*(Rm – Rf), where
Rf = Risk-free rate
Β = Beta of the stock
Rm = Market rate
Of course, we can rearrange the Re equation –
Re = Rf + β*(Rm – Rf)
By the way, this equation in finance is called ‘The Capital Asset Pricing model’ or CAPM.
