Cost of capital and DCF

valuation A Review
Session 1
FM-II, Term III
IIFT, Delhi
 FCFF valuing the firm
Value of firm = FCFF0(1+g)/(r g),
whereEBIT (1-t) Firm Firm
Reinvestment
Reinvestment
rate * ROC
EBIT (1-t)/ (Long
[(Capex Depn) + Net Firm Reinv./ Term Debt +
Working Capital] EBIT(1-t) Equity)

Current Assets -
Current Liabilities WACC= kd (1-t)*[D/(D+E)] + ke*[E/
(D+E)]

Operating
Return on Total
Income (EBIT (1- Firm capital Cost of Capital
Capital
t))
 Impact of leverage on
enterprise value
Unlevered Levered firm
firmLiabilities side Assets side Liabilities
Assets side
side
Net fixed Net fixed
assets assets Debt

Net working Net working

Equity
capital capital
Equity

Net other Net other

assets assets
Asset beta = Equity beta Asset beta = W(E)*(E)+
W(D)*(D)
How do MM theorems fit in here?
Un-levering and re-levering beta as per CAPM
What is the assumption around risk of debt?
What are the implications for valuation?
 WACC and its implications

WACC= kd (1-t)*[D/(D+E)] + ke*[E/(D+E)]

What does the discounting rate for a cash flow signify?

Kd = Nominal Rf + Premium for risks (Default, Political)
Ke = Rf +(Equity Risk Mkt Premium)
Computation of WACC uses market value weights, not book
values
Current vs. target capital structure?
Should a multi-business firm use a single WACC for all divisions
or divisional WACCs? Implications of using a single WACC?
Impact of capital structure on beta: Levered (Regression) beta
vs. unlevered (asset) beta
Un-levering and re-levering beta to account for different levels
of leverage
 Does WACC stay constant over time?

WACC= kd (1-t)*[D/V] + ke*[E/V]

A. V0 = FCF1/(1+WACC1)
B. WACC1 requires Market value of firm (V0) as an input
C. Hence,
a. There is a circularity in computation of value using
FCF methods, and
b. WACC is a dynamic number that keeps changing
with change in capital structure and value of the
firm
c. Becomes a cumbersome method to use in cases of
restructuring where capital structure undergoes
massive changes
To get from firm value to equity value,
which of the following would you need
to do?
A. Subtract out the value of long term debt
B. Subtract out the value of all debt
C.Subtract the value of any debt that was
included in the cost of capital calculation

Doing so, will give you a value for the equity

which is
A. greater than the value you would have got in
an equity valuation
B. lesser than the value you would have got in
an equity valuation
C.equal to the value you would have got in an
equity valuation
 Inflation in DCF modeling
Real vs. nominal cash flows; Real vs.
nominal discount rates
Impact of inflation on interest and
depreciation tax shields
Impact of inflation in cross-border
deals or multi-currency valuations
 Extensions to the CAPM
Arbitrage Pricing Theory (APT)
Fama & Frenchs 3-factor model A
special case of APT