Fabrice Bienfait

Table of Content Introduction..................................................................................................................................... 2 Enterprise Valuation ....................................................................................................................... 2 The Weighted Average Cost of Capital Approach ......................................................................... 2 The Adjusted Present Value Approach........................................................................................... 4 The Capital Cash Flow Approach................................................................................................... 4 Numerical Example ........................................................................................................................ 5 Conclusions..................................................................................................................................... 7 References....................................................................................................................................... 8 Figures and Tables Figure 1: WACC as a Function of the Debt Ratio .......................................................................... 3 Table 1: Assumptions (in €)............................................................................................................ 5 Table 2: WACC Valuation (in €)................................................................................................... 5 Table 3: APV Valuation (in €)........................................................................................................ 6 Table 4: CCF Valuation (in €) ........................................................................................................ 7

Fabrice Bienfait

IFM Final Paper

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Introduction In this note we compare and contrast three enterprise valuation models: the weighted average cost of capital (WACC), the adjusted present value (APV) and the capital cash flow (CCF). The three approaches value the entire firm but they differ around the way they treat tax shields. We will first review the rational and the underlying assumptions behind each approach. We will then use a numerical example to illustrate the mechanics behind the three approaches and show under which assumptions they yield the same results. Enterprise Valuation According to Modigliani and Miller, the value of a company’s economic assets must equal the value of the claims against those assets. Enterprise valuation models value the sum of the cash flows to all claim holders, including equity holders and debt holders and discount them to the appropriate cost of capital. The cash flow available to all claim holders is called the free cash flow (FCF) from operations and is defined below: FCF = EBIAT + Depreciation – Capital Expenditure – Increases in Working Capital EBIAT is the income the company earns after tax without regard to how the company is financed. Non-cash expenses such as Depreciation are then added. Because we are valuing a going concern we also take into account the cash flow management will retain for new capital expenditures and possible increase in working capital. The remaining is in effect the cash available to owners and creditors. By definition free cash flow is independent from leverage (and is often referred as un-levered free cash flow). Therefore the value derived from the interest tax shield (interest on debt is tax deductible) has still to be incorporated in the enterprise valuation. This is where the three approaches WACC, APV and CCF differ: • The WACC approach values the tax shield by adjusting the cost of capital • The APV approach values the tax shield separately from the un-levered free cash flow • The CCF approach values the tax shield by incorporating it in the cash flow The Weighted Average Cost of...