Chapter 2 Part 1

Chapter 2 Part 1 - II. Security Selection B. Firm Valuation...

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II. Security Selection B. Firm Valuation and Equity Valuation Three Approaches to DCF Valuation There are three ways to implement this model in practice: Dividend Discount Model, Equity Valuation (FCFE), Firm Valuation (FCFF). The basic ingredients are always of the same type, Existing cash flows, Growth rates, Discount rates, A terminal value. The key error to avoid is mismatching cash flows, growth rates and discount rates. For example, discounting cash flows to equity at the weighted average cost of capital will bias the estimated value of equity upward. Cash Flows, Growth and Discount Rates Dividend discount Model Existing cash flow: current dividend Growth rate: growth in equity earnings (net income). growth rate = (retention ratio) x (return on equity) Discount rate: cost of equity Equity Valuation Existing cash flow: FCFE = net income - capital expenditures + Depreciation - change in working capital - net payments of debt principal
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Chapter 2 Part 1 - II. Security Selection B. Firm Valuation...

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