Different DCF & WACC techniques (valuation: article 9 of 12)

Article 9 of 12: Valuation: Different DCF & WACC techniques

Author: Joris Kersten MSc

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Different DCF techniques

Most people who use the cost of capital are interested in valuing businesses or shares in a business. And by far the most robust and frequently used technique is the discounted cash flow valuation (DCF).

Concerning DCF there are three widely used methods to calculate the present value of a company:

1. The standard WACC approach;

2. The flows to equity method;

3. The adjusted present value approach.

Let’s now take a look at these methods in more depth.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Standard WACC approach

The most commonly used method in the world of corporate finance is the standard WACC method. The first step of the WACC approach is to estimate the operating cash flows that would be available to the providers of capital to the business after corporate taxes are paid.

These cash flows are also called “free cash flows”, a term you might have heard before. But be careful, these cash flows do NOT take into account any reductions coming from the “tax shields” from interest payments.

So we refer to the tax in the free cash flow calculation as: “Unlevered tax”. This because the tax is estimated on the same basis as if the business was unlevered, so in this case the corporate tax is not reduced by any tax relief on interest payments.

It is necessary to asses the cash flows on this unlevered tax basis, because our standard WACC formula already includes an adjustment to the cost of debt. So this approach does not ignore the implications of debt financing.

This since all of the debt implications to the equity holders of the business are reflected in:

1. The gearing adjustment to equity betas. These capture the increased risk from the presence of debt;

2. The reflection of the tax benefit in the WACC (tax adjustment to cost of debt in WACC);

3. The impact of debt on the overall discount rate, where the cost of debt is weighted in the capital structure;

4. The deduction of debt (at its market value) from enterprise value to calculate the equity value.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Characteristics of a standard WACC approach

The approach assumes that the company adopts a single capital structure for the projection period and terminal value.

This assumption on the long-term capital structure is made with reference to actual data on both the company and peer group industry norms. I have discussed this in more detail in the previous blogs.

The approach typically uses the CAPM (capital asset pricing model) for the cost of equity calculation. I have discussed this before, but it means that equity providers require a premium above the risk free rate that reflect the “systematic risk” (also called market risk) associated with the investment.

Also a “leveraged equity beta” is used and this beta reflects the riskiness of shareholders returns that arise as a result of fixed “debt service” commitments.

The conventional formula that is used to lever an asset beta (unlevered beta) to a levered equity beta is: Beta equity = Beta Asset * ( 1 + debt/ equity ). This formula is called the: “Harris Pringle Beta Formula”.

At last, a terminal value is most often calculated as a perpetuity. This is calculated as the annual free cash flow at the end of the projection period. And then plus one year’s growth divided by the estimated long term WACC less the growth rate.

This growth rate is that for the sector in which the company or division operates. And normally it would expected to be the same as the economy growth rate to which the company is exposed (GDP).

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Flows to equity approach

A second DCF approach is the “Flows to equity” (FTE) approach. The FTE approach gets an estimate of the present value of the equity (market value of equity).

This based on a post-interest and post corporate tax cash flow of a business. So here you can notice that there is no debt component in the discount rate.

The cash flows are discounted using a “leveraged cost of equity”, the same cost of equity that is used in a standard WACC. So the beta is here adjusted for the financial risk of debt.

This method does not require practitioners to deduct a market value of debt from the calculated present value. And this method is useful for valuing financial services firms where the company’s funding structure is there to make money.

These companies make money on the spread between borrowing and lending, so debt financing is not a financial engineering decision, but becomes part of normal day-to-day business decisions.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Adjusted present value approach

A third approach to DCF valuation is the adjusted present value (APV) approach. It basically claims that the value of an asset is dependent on two factors:

-The fundamental value from the operation of the asset;

-The value associated with the finance structure (basically interest tax shields).

The method treats a company like it is debt free in order to calculate the fundamental value of the business. And then it looks at the value that comes from the debt financing in a separate calculation.

For the value of the operations, post-tax unlevered cash flows are discounted using an unlevered cost of equity. This implies that the assumption is made that there is no debt.

And then there is the value from the interest tax shield. The discount rate that should be used to calculate the present value of the interest tax shield, should reflect the risk associated with obtaining the tax deductions.

Fixed level of debt financing (irrespective of enterprise value)

If a company is able to maintain a fixed level of debt financing, which will never need to vary in response to changes in the market value of equity (and enterprise value), then the risk to the interest tax shield arises from the risk to the company's tax rate and the risk to the company’s existence.

These risk factors are probably the best reflected in the “cost of debt”, as they are similar to the risk that bond holders in a company face.

So with this assumption (begin able to maintain a fixed level of debt, irrespective of enterprise value) the “cost of debt” is probably the right discount rate for the present value of the interest tax shield.

Constant gearing ratio (depending on enterprise value)

When a company needs a constant gearing ratio then the level of debt financing will vary to the variation in enterprise value.

As we know, the "unlevered cost of equity" estimates the discount rate that investors use to calculate enterprise value, when the company is entirely financed with equity.

But as the interest tax shield will vary in line with enterprise value (when there is a constant gearing ratio assumption), this suggests that the unlevered cost of equity is the right discount rate to use to value the interest tax deductions for such a business.

In practice …

The freedom of a company to control its capital structure will lie between the two extremes mentioned above: fixed level of debt and constant gearing ratio.

For example, let's assume a company faces pressure to maintain the gearing ratio broadly in line with the “target ratio”. But it does not need to change it's gearing ratio instantly in response to a change in enterprise value.

Then the appropriate discount rate would lie in between the "unlevered cost of equity" and "cost of debt".

And judgement is still needed from the practitioner!

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.